Saturday, February 19, 2011

Stay the Course

Blogger Mark Miller at Reuters posted about a recent study from the investment firm T. Rowe Price which shows how different responses to the bear markets of past ten years affected the savings of retirees.  The results are quite interesting.

T. Rowe Price starts with a hypothetical person who retired on January 1, 2000 with $500,000 invested 55% in stocks and 45% in bonds (a typical asset allocation for somebody entering retirement).  They assumed that this person would follow a common strategy of withdrawing 4% a year with adjustments for inflation.  This person would withdraw $20,000 in the first year, and then increase his/her withdrawals each year based upon inflation.  As you know, between the beginning of 2000 and now, we endured two serious bear markets:  the dotcom bust of 2001-2 and the Great Recession of 2008-9.  T. Rowe Price ran a simulation of what would happen if this person reacted to the bear markets in different ways:

1. Do nothing.  Continue to invest in 55% stocks and withdraw money using the same strategy.

2. Keep the same asset allocation, but reduce withdrawals by 25% for the three years following each bear market.

3. Keep the same asset allocation, but don't adjust withdrawals for inflation for the three years following each bear market.

4. Switch to a "safer" 100% bond portfolio, and continue to withdraw money using the same strategy.

T. Rowe Price calculated the percentage change that this person would run out of money before the age of 95.  As you can imagine, reducing withdrawals increased the odds of not running out of money.  Strategy 2 had the best chance of success (84%), while Strategy 3 had the second best chance of success (69%).  Doing nothing (Strategy 1) had only a 29% chance of success.

The most interesting thing to me as that Strategy 4, the one where the person got out of the stock market altogether, had a 0% chance of success!  The funny thing is that I would suspect that getting out of the stock market the strategy that most people would actually follow!

The lessons here are:

1. Staying the course with stock market is extremely important, even for retirees.  Why?  Because over the long term, the growth that stock investing provides not only helps to build a nest egg for those saving for retirement, but it helps to prolong that nest egg for those in retirement.  You might think that as a retiree, you can't take on the risk that stock investing entails because your time horizons are so short.  However, with life expectancies what they are, many people can expect to spend 20 years or more in retirement.  Historically, over any 20 year period, the return of the S&P 500 stock index is positive.

2. Spending less is the best strategy for keeping your retirement savings from running out before you do!

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