(Photo Credit: Yahoo Finance S&P 500 historical graph through today.)
As I mentioned in my previous post, the big consolation prize of this election has been its effect on the stock market. I’m not sure this is what the voters who elected this administration had in mind, enriching a young retiree who basically sits at the piano all day long. But hey, I’ll enjoy it while I can.
And that’s the point of this post. A cautionary tale to enjoy it while you can but prepare yourself for the inevitable recession. I can’t tell you when or how deep it will be, but there will be another recession. We are currently enjoying the third-longest expansionary period in U.S. history. And it’s pretty close to pulling into second place.
I retired in 2008 just before a whopper of a recession and in retrospect, I had too much of my portfolio in equities to be able to rest comfortably. At the time, I had a 70% allocation to stock mutual funds and 30% allocation to bond funds and cash. As it happens, that was enough to get me through the downturn without having to sell stock funds at bargain basement prices, but it was a little too close for comfort. After the market recovered, which took almost seven years by the way, I switched to a 60/40 allocation. So next time we ride the rollercoaster down, I won’t be quite so queasy.
Of course the market may continue marching upward for years before the inevitable downturn, but if I were retiring for the first time right now, I’d be assuming the market is more likely to go down in the not-too-distant future than to go up. And I’d have an allocation right now that would allow me peace of mind even if it took seven or more years to recover.
It’s tough to know exactly what that allocation is without living through a rough patch. But I encourage you to run some numbers now. See how your finances would look if your stock funds lost 46% of their value. That is not a hypothetical, that’s how much the market went down the first year I was retired.
If you are getting ready to pull the trigger on retirement, here’s my advice:
- Take a look at your current nest egg. Divide that number by your living expenses that will not be covered by other income sources such as Social Security or pensions. If you are 65 years old, that number should be right around 25. The larger it is, the better shape you are in. That represents how many years’ living expenses you have before accounting for inflation and earnings on that nest egg. History shows that should take you no less than 33 years through retirement, even if our markets experience markets matching the worst 33 years in the last century.
- Now, take a look at your stable liquid assets–cash, CD’s, short-term bond funds. Divide that number by your living expenses that will not be covered by other income sources. As a point of reference, it took the stock market almost seven years to reach the peak level it achieved in 2007 before the recession. Do you have enough to live on if it takes that long again or will you be forced to sell some of your stocks at huge discounts to keep your head above water? Any stock you sell at the bottom represents gains you will never see again when the market goes back up. You’ve made those losses permanent.
- Take your portfolio and multiply the equity side of it by 46%. Now subtract that number from your total portfolio. Divide the result by your annual expenses not covered by other sources. How different is that than the number you came up with in #1–the one that was hopefully around 25? Try one more thing. Divide this reduced portfolio by the number you came up with in #1. Can you figure out a way to live on the resulting number instead of the number you were counting on?
- Historically, if you retired with 25 times your expenses at age 65, you’d likely be ok even without adjusting your spending. But how does the hypothetical situation in #3 FEEL to you? Doesn’t it make you FEEL like making some cutbacks? It made me feel like cutting back expenses in 2008 (and 2009 and 2010!)
Despite the fact that I had three years of cash available to me in 2008 and another few years in short-term bond funds, I’ll remind you, I was nervous. My 70/30 allocation was too aggressive to allow me to rest well. But a large part of our budget was discretionary spending. So we made adjustments. We held off on big vacations and when we did travel, we used airline miles and home-exchange. We took it easy on the entertainment and eating out. We lived significantly under budget for the first three years of our retirement.
What else might you consider in a protracted downturn? Do you have a plan for downsizing, picking up part-time work, or a reasonable expectation of inheriting money in future? How would you make it work if you had to weather that kind of a storm?
One more exercise I would suggest. Try all of the above again with a portfolio allocation more heavily weighted toward cash and bonds. How does that feel? Maybe you need a more conservative allocation. It has to feel right to you.
I’m not saying I expect to endure that severe of a recession again, but why not be prepared just in case. Don’t just base your retirement plan on your “number” today. It might not be that number anymore tomorrow, or next year, or the year after that.
Maybe we will be the lucky ones, the ones with the longest expansion in history. Nothing lost for you then. You were prepared for the worst and then got to enjoy the best.
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