Avoid Tapping Your Nest Egg in a Down Year

Updated on January 30, 2008.

ONE OF THE MOST important investment decisions you will ever make is not whether to retire but when you choose to do it. Every American looks forward to the day when they can trade the 9-to-5 grind for a little bit of well-deserved rest and relaxation. But the easiest way to erase decades of smart saving — picking the right funds, contributing the right amounts — is to start taking big withdrawals at the wrong time, especially if the stock market is in the midst of a prolonged slump.

By tapping an account during a down period, investors run the risk of eating into years of valuable retirement income that they may never be able to regain. They may have the money today but as the typical American starts to live well into their 80s they may not have that money down the road. This is particularly important now since there is a lot of uncertainty in the market. Luckily, there are some easy steps you can take, like getting a handle on what financial pros call your investment horizon, to help you insulate yourself from this problem.

And what a problem it is. Moshe Milevsky, an associate professor of finance at York University, presented a retirement conference audience with two identical $100,000 portfolios whose owners, he said, would remove $9,000 from their balances every year. Despite having similar average annual returns and standard deviations over the long haul, one portfolio started with a three-year average return of -5.6% while the other enjoyed a 22.1% average annual return during the same time period. After the first three years the portfolios ran through similar market swings.

Milevsky found the first portfolio, the one experiencing negative returns right out of the gate, lasted just 15 years into retirement while the second portfolio still had a balance of $105,000 20 years later. People who retired in 2000 know that scenario all too well. Many portfolios ballooned during the late 1990s tech boom. But a hypothetical $500,000 nest egg would have been almost halved in size by 2002 thanks to the bear market and periodic withdrawals of 5%, just about the payout level advisors are comfortable with.

There are a few quick fixes, like continuing to hold down a job, avoiding withdrawals until the IRS forces you to take them after you turn 70 1/2 or cutting your living expenses. On a $1 million account shaving just 1% in expenses means an additional $10,000 that will earn returns when the market recovers. A new job may offer some mental stimulation or valuable health benefits, but check first to make sure this new stream of income doesn't lead to a larger portion of your Social Security payments getting taxed. "It's a common sense solution," says Keith Newcomb, a principal with Full Life Financial in Nashville, of working more or scrimping, but one, he says, he prefers his clients avoid.

Additionally, you can give your portfolio some added insulation by living a healthy lifestyle. A recent Fidelity study estimated the typical 65-year-old couple retiring this year will need about $215,000 to pay for the medical expenses they will incur during their later years. This approximation is up 7.5% from last year and will certainly rise going forward. "A significant amount of retirees told us their state of health is not good, they are spending more in retirement than they ever planned," said Brad Kimler, senior vice president of Fidelity's employer services business, when the report was announced in March.

To keep punching a clock or living frugally or hitting the gym doesn't sound like a particularly fun way to start what should be some of a retiree's most rewarding years. That's why financial advisors spend a lot of time figuring out what's called your investment horizon. This is the smartest option.

This process starts years before you turn 65 and looks out well into your retirement. If you wait too long to do it, well, it's your own fault if retirement starts off a bit rough. "If investors are in that position then they haven't done everything right," says Newcomb. "They need to be in a position where they aren't so vulnerable to risk."

Mapping out your investment horizon depends on many factors, several of which you will just have to ballpark. These factors include your probable retirement date, how long you think you may live, what kind of lifestyle you will keep, any travel plans or vacation home purchases — essentially it will put into focus what the last 20 years of your life will look like. It can be daunting to make such predictions, but advisors armed with this knowledge will use it to make key decisions about your retirement account, especially when it comes to asset allocation.

The old adage about asset allocation during retirement was this: Take your age, subtract it from 100 and that is the amount your portfolio should be exposed to stocks. However, your advisor shouldn't still be using this outdated formula. That's because if you're fortunate to see 90 it means your account not only needs to generate 25 years of income but it will also experience several up and down market cycles. To be locked into such a conservative portfolio, especially when the market rallies, could actually cost you returns. "That isn't going to get the job done," says Jeff Buetow, the chief investment officer of XTF, an investment shop in New York. Today some advisors suggest subtracting your age from 120 instead.

While advisors still like retirees to be exposed mostly to bonds, the debate now is exactly when a majority of the account should be put into them. This argument is no more apparent than in target-date offerings, which recalibrate to bonds from stocks as they near a specific date. Almost all of these funds vary in their bond exposure at retirement. For example, the Vanguard Target Retirement 2010 fund currently has 44.1% of its assets in stock funds, including some international and emerging-market offerings. And some advisors favor dividend-paying stocks, which provide extra income with the cash payments they kick off.

Manipulating these different asset classes can have a profound effect on your savings, regardless of whether you retire during a bear market or not. We suggest having around half of your portfolio in bonds or income-producing investments around the time you turn 65. Consider this: Remember our retiree who stopped working in 2000 only to see his $500,000 portfolio shrink by half just two years later? If that same person had taken some profits and balanced their portfolio evenly between stocks and bonds before the downturn he would have come out of the bear market with just a paper loss of around $10,000. Now that's the right way to start your retirement.