To be clear, the U.S. is not in a recession currently. However, due to current economic factors, such as persistently high inflation, record low unemployment, supply and demand imbalance, and continued quantitative tightening by the Fed, many wonder if the U.S. might be in a recession before the year is over. Fed Chairman, Jerome Powell, stated that he wants to continue to tighten the money supply through raising interest rates and decreasing the Fed’s balance sheet until inflation is closer to 2%. For seven months straight, inflation has consistently decreased, but not at the rate desired.[i] Inflation as of January 2023 stands at 6.4%, down from the high of 9.1% in June 2022. Despite this improvement, inflation remains four and a quarter percent above target. As a result, the Federal Open Market Committee (FOMC) which decides fed policy, has openly stated that they plan to continue to raise interest rates for the foreseeable future in 2023.
Generally speaking, when interest rates increase, spending decreases, as the cost of borrowing becomes more expensive. When widespread consumer spending decreases, corporate revenues decrease, and that can lead to a declining stock market. We’ve seen this occur in our current market as corporations with shrinking revenues have turned to layoffs in an effort to keep their bottom line profit intact, in a new lower revenue environment. There are a lot of variables and technical nuances that tie these cause and effect events together, and the conclusion doesn’t always play out as originally anticipated. However, this general fear of future potential economic slowdown is what drives the stock market movements we see today. That is because the stock market is commonly pricing into the market today, the events it forecasts coming to fruition six-months to a year into the future.
For a new retiree or working person on the verge of retirement, these scenarios can lead to a lot of stress. Retirement often means leaving behind the comforts of a regular and reliable paycheck. It can also mean, revisiting your budget, for a landscape with lower income, but possibly the same expense structure. Often retirees admit they became financially comfortable in their highest income earning years and didn’t have to watch their spending too closely. As a result, budgeting for retirement can be a fearful experience, especially if it wasn’t given much attention in recent years.
A common very simple approach to budgeting is the 50/30/20 framework. The first 50% of your budget should be allocated to necessities, such as your basic living expenses: food, mortgage/rent, auto/transportation, and so forth. The next 30% can be allocated to things you want, such as entertainment, dining out, travel and gifts. The last 20% should be reserved for debt repayment and emergency savings. A lot of retirees have a goal of paying off their largest debts, such as mortgages, auto loans and credit card bills by the time of retirement so that there is more cushion in the budget. Therefore more of the 20% allocation can provide a safety net for unplanned expenditures, such as home or auto repairs/maintenance, or potential future health expenses.[ii]
Some retirees benefit from stable retirement income sources such as social security or pensions. However, pensions are few and far between these days, and social security is not enough to live off alone. Therefore, many retirees depend upon systematic distributions from their work retirement savings plans (401Ks 403b, 457) that are rolled into an accessible IRA at retirement. Continuing the discussion of budgeting, it is important to assess what a safe withdrawal rate is from retirement assets to support your retirement income needs, but not deplete the investment account prematurely during your lifetime.
Many quote the 4% rule, which states you can likely withdraw 4% from your investment portfolio annually, both in good markets and bad markets, and if the future market returns are consistent with historical returns (booms and busts) of the past, you should not run out of money during your lifetime. This 4% annual distribution can be increased annually by the inflation rate over the next 30-some years of retirement, and you should be able to count on market rates of returns in the portfolio to sustain your systematic distributions. You may have noticed there are a lot of “if’s” and “should’s” in this statement and that reminds us that past markets are not indicative of future market performance.
This often quoted rule of thumb was calculated by financial planner Bill Bengen in the mid-1990s, when Money Magazine pushed the envelope saying retirees could safely take 10% out of their portfolios annually. At the time, stocks had generated an average return of 10% since the 1920s, and the Dot Com bubble had not yet burst. In his research, Bengen had a theoretical $1 million dollar retirement portfolio and distributed 10% each year, starting from 1926. The 10% distribution portfolio was depleted in the Great Depression. Bengen then adjusted the distribution percentage and ran the scenario multiple times over various retirement windows, eventually coming to the conclusion that 4%+inflation was the safest balance that allowed a retiree to live comfortably but not be upturned in an unexpected market dip. Bengen’s 4% portfolio survived both the Great Depression and the stagflation years including 1974 and 1975.[iii]
While a 10% distribution is more desirable, it was not sustainable long-term. That’s because if you are taking distributions during bear markets (or worse, a recession), your investment portfolio is declining by the market downturn, and you are locking in those losses with the untimely distribution. This prohibits the portfolio from possibly recovering in the months or years ahead, and leads to less investment return going forward. Bear markets are inevitable, and are actually a healthy checks-and-balance system to prevent bubbles from forming in the stock market. A blend of two scenarios is dynamic distributions, where a retiree takes out more when the market is up and uses up cash reserves during market downturns to allow the investment portfolio to recover.[iv]
If you are lucky and you get a streak of good market return years right off the bat in retirement, this can positively shape your distribution schedule for your retirement ahead. However, if instead you retire when the market declines, you can be subject to sequence of returns risk, or risk of causing permanent damage to your retirement portfolio due to subsequent ill-timed events, a.k.a: bad timing.
Working with a skilled financial planner can help you navigate the complexities of retirement planning. Many retirees have several buckets of assets, including traditional tax-deferred IRAs, tax-free Roth IRAs, and taxable accounts where you are only taxed on the gains at preferential capital gains tax-rates. You may want to strategically distribute from different assets at appropriate times to manage the stock market volatility and control your taxes more efficiently. On the most basic side, a retiree may choose to simply stick to the safe 4% distribution rule with no alterations. However, if there is no extreme market drop, that strategy can possibly lead a retiree to regret, as they could possibly end up with a huge unused nest egg at the end of life that could have been utilized for better quality of life. These are all important considerations that are essential in creating a successful retirement plan that can withstand the test of time. The most prudent approach to retiring successfully may be to set a good retirement plan, but also be open to evaluation and flexible to adjustments along the way. Planning early can allow you to utilize the power of time and also take advantage of tax opportunities in our constantly changing legislative environment. When you plan correctly, even the down years are an essential part of a long-term financial plan as they provide a good buying opportunity to purchase stocks priced low, adding to the growth of your nest egg for the future. Reach out to your Certified Financial Planner™ or CPA Personal Financial Specialist (PFS™) if you feel you could benefit from a financial plan to weather retirement in whatever market conditions lay ahead.
[ii] Bob Veres Insider Information