WallStreet Journal
Dancing Bears at Your Retirement Party?
Sunday March 30, 2008 2:02 am ET
By Tom Lauricella

With stocks down and home prices falling, people entering retirement or on the verge of punching the clock for the last time face some unpleasant math.

While no one knows precisely where stocks are headed or when home prices will bottom out, those counting on personal investments or a home sale to produce much of their income after leaving the office may have to postpone retirement, cut back spending plans or find a part-time job.

Typically, investors are taught to think long term and not worry about the financial ups or downs that happen in any given year. But big moves over a short period of time -- particularly in the first few years of retirement -- can have a significant impact on the likelihood of retirees having enough money to last the rest of their lives.

With stocks showing double-digit declines from highs in October, this is one of those times.

"We talk about all kinds of risk in investing and how they can be managed, and there is also a 'timing risk' related to when somebody retires relative to what's happening in the market," says Jack Brod, who heads up asset management services at Vanguard Group.

"If you happen to retire at a time when the markets are in a downturn, it's particularly important to recognize that and adjust as much as you can."

According to T. Rowe Price Group, losses or even subpar returns in the stock market during the first five years of retirement "significantly increase" the chance of retirees outliving their money. The reason is that during retirement, any money taken out isn't reinvested to take advantage of a market rebound. (If you can get safely through those first five years, the effects of a weak market aren't as debilitating; that's because your nest egg, ideally, has had a chance to grow.)

T. Rowe Price ran the math for an investor who is retiring with a $500,000 portfolio that is invested 55% in stocks and 45% in bonds. The hypothetical retiree withdraws 4% from the portfolio in the first year and increases the dollars withdrawn by 3% annually to adjust for inflation. That person has an 89% chance of that money lasting 30 years, T. Rowe Price says.

(These calculations are based on computer models known as Monte Carlo simulations, which consider thousands of scenarios for the markets.)

However, the likelihood of success falls sharply if during the first five years of retirement the portfolio returns less than 5% a year. At an average 4% a year, the chance of having the nest egg last 30 years falls to 74%. If returns are only between 2% and 3%, there would be a 64% chance of not running out of money, according to T. Rowe Price.

To make things worse, home values -- a major factor in many people's retirement equations -- are plunging in many areas of the country. The S&P/Case-Shiller index for home prices in 20 U.S. cities showed a drop of 10.7% in January from the year before. Prices in some cities have tumbled 20%.

The math on declining home values is most challenging for retirees who still have a mortgage and can see a big cut in their equity in the home, notes Christopher Jones, chief investment officer at Financial Engines, which provides asset allocation services to 401(k) plans.

Consider a home whose value falls 15% from $600,000 to $510,000. If there's a $300,000 mortgage, the equity in the house drops 30%, to $210,000 from $300,000.

For some investors -- those with a big enough cushion in their portfolio -- the declines in stock and home prices may not drastically change their prospects for having sufficient retirement income. But for those with a rising risk of falling short, the question is how to respond.

For somebody making the decision about whether to retire right now, Christine Fahlund, senior financial planner at T. Rowe Price, thinks the safest idea is to keep working.

"Retiring into a down market is generally not a good idea," she says.

For those already in retirement, the temptation may be to shift out of stocks until the worst is over. That's probably not a good idea. Trying to time the market is hard enough for the pros. What's more, being invested when the rebound begins is crucial to generating long-term gains.

T. Rowe Price found that, in the 2000-2002 bear market, the best strategy was to reduce the withdrawal amount until the probability of success returned to a comfortable range.

For instance, an investor with a 55% stocks/45% bonds mix might have trimmed withdrawals by 25% in 2002, continuing until early this year.

Allan Roth, a financial planner in Colorado Springs, Colo., uses Monte Carlo simulations to assess appropriate withdrawal rates for clients. When real-life investment returns diverge for a year or more from expected returns, he says, adjustments need to be made based on how far off the portfolio is from the levels needed to reach the retirement-income goal.

For instance, say a portfolio loses 5% in a year when the expected after-inflation return was a 3% gain. That shortfall of eight percentage points would suggest roughly an 8% reduction in the withdrawal amount, Mr. Roth says.

He recommends looking at this annually -- as he does for clients -- and not reacting to returns over shorter periods.

encore@wsj.com



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