I’m probably getting ahead of myself a bit, but I’ve started thinking about contingency planning. What set of circumstances would drive us from early retirement back into the wealth accumulation phase? While we have a goal to “retire” as soon as possible, we’re certainly not going to take any outlandish risks to get there.
Because we plan on living off the appreciation of accumulated assets primarily in the form of stocks (held in indexed mutual funds), I feel there are two (2) main risks to our retirement status. The first of which I’ll cover in this post.
Risk 1: Market Volatility – downturns early in retirement
Fluctuations in the market are a fact of life. While in the accumulation phase, I’ve found it to be relatively easy to overlook the short-term volatility in the interest of long-term gains. But as someone who will continue to be dependent on the market during my retirement, I’m particularly interested in one thing: the risk of negative returns early and often immediately after hanging up my ‘working-for-the-man’ shoes.
To best understand how market volatility can affect the longevity of my portfolio, let’s take a look at the following hypothetical retirement example. The illustration below shows three different scenarios, each with the following assumptions:
- Starting nest egg: $1,000,000
- Year 1 retirement withdrawal: $40,000
- Inflation: 3% per year
- Withdrawals increase with inflation
You can see that each scenario averages a 7% return across the first 10 years of retirement but that the returns are reversed. Scenario #1’s retirement starts out with strong returns and ends poorly whereas Scenario #3 starts poorly and finishes strong.
Note the value of the nest egg in Year 10 of retirement for each of the scenarios.
- Even though all three scenarios returned an average of 7%, the order in which those downturns occur really has an impact on the remaining balance of the nest egg. In this example to a tune of about a 35% difference.
- The Static 7% Return (blue) line is often how I predict the future value of my nest egg but really isn’t a valid representation of how the market actually fluctuates.
- When your retirement portfolio is heavily dependent on the market, your first couple of years of returns can either make or break you. It really sets the tone as to whether or not your money is going to last.
For kicks and giggles, I did a similar exercise with historical S&P 500 data because I wanted to see what 2008’s massive tumble of 37% would look like to the remaining nest egg charts.
The following image shows the 15-year stretch between 1994 and 2008. While this probably shouldn’t be all that surprising, look at the difference of incurring a 37% drop in the first year (Scenario #3) of retirement versus the 15th year (Scenario #1). Over a $1 million difference! Granted, I’m hoping this is an extreme example, but certainly shows how devastating one negative year soon after retiring can be.
So what does all this mean?
Well, I’m certainly not going to let this scare me into working long after we’ve reached our number because of something that *could* happen. I’m pretty poor at timing the market so I have just as great a chance hitting the market on an upswing as I would on a downswing. And as the graphs show, retiring on an upswing will make me wish I had retired sooner!
Some practical things I can do if I find myself on one of the red lines early:
- Maintain a more conservative asset allocation (before retirement)
- Adjust spending on niceties like travel during the down years
- Work part-time to lessen the yearly withdrawal amount
- If things are bad enough, I suppose I could hit the Early Retirement Ejection Button and go back to full-time work. This would be the last resort and something I’d much rather need to do after retiring in my 40’s than having to face this option in my 60’s.