IRA Distributions and a Slumping Stock Market: The Retirees Double Whammy

NOVEMBER 2002

IRA Distributions and a Slumping Stock Market

The Retiree’s Double Whammy

The First Problem: In the past two and a half years, many investors have seen their retirement nest eggs shrink as the stock market slumped to its lowest level in five years. The obvious concern is that the prices of our investments have declined and, therefore, reduced the amount of our capital available to provide for future living expenses.

The Second Problem: There is a more subtle concern that has affected retired investors that have been living on their retirement investments. Ongoing distributions from retirement accounts for living expenses have, in many instances, been just as damaging to principal as hefty stock market declines.

Setback #1: Let's look at a retiree with a $500,000 retirement account in March 2000, just prior to the longest, deepest stock market decline since the 1930’s. We’ll assume that this investor was not 100% invested in the stock market. Instead, they were invested more conservatively. Their capital was allocated as a classic 60/40 “balanced” portfolio, that is, a mix of 60% stocks and 40% bonds.

Whereas the stock market (Standard & Poor's 500 stock market index) declined 44% through the end of September, this investor fared much better and averted more than half of the damage. Instead of a 44% decline, this retiree limited their investment losses to 20% because the profits on their bond investments helped offset the losses on their stock investments. Cumulative investment losses of 20% over a two and a half year period are certainly a harrowing experience, but not nearly as disastrous as a decline of 44%, or even worse, a near wipe out of 75%+ for investors that were heavy in technology and internet stocks.

Setback #2: Investment losses are only half the story. The other half has nothing to do with the stock market. The subtle, yet equally significant setback to this retiree’s portfolio is the impact of ongoing withdrawals to meet living expenses.

Ongoing distributions from retirement accounts for living expenses have, in many instances, been just as damaging to principal as hefty stock market declines.

The Double Whammy: In this example, the retiree started with $500,000 in early 2000. Let's also assume they were taking withdrawals for living expenses that totaled 8% per year, that is, $40,000 per year. Their cumulative withdrawals over the past two and a half years totaled $100,000. Restated, during the past two and a half years they have withdrawn 20% of their initial $500,000 capital to meet living expenses (8% per year times 2-1/2 years equals 20%.) Combine that with investment losses of 20%, and this retiree’s capital shrunk by 40%! A nest egg that was $500,000 two and a half years ago has been reduced to only $300,000 even though their investments performed much better than the stock market!

Making the Best of a Tough Situation

What is Your Plan - Chance or Choice? Unless this retiree is blessed with incredibly favorable future investment returns, some constructive action needs to be taken to prevent their capital from eroding further. Although several years of very high investment returns might do the trick, relying on good luck is a dangerously shortsighted and risky plan to achieve financial security. This retiree needs to take positive steps to control their fate.

An annual distribution rate that started out at 8% (distributions of $40,000 per year divided by $500,000 of capital equals 8% per year) has become 13.3% (the same distributions of $40,000 per year, but divided by $300,000 of remaining capital equals 13.3% per year.) That’s a giant problem when you consider that long term investment returns have been roughly 10% for stocks and only 5% for bonds! In other words, they are taking money out of their retirement account faster than they can reasonably expect to earn money in their retirement account. This retiree is virtually assured that their annual distributions will deplete their capital and they will run out of money.

This begs the question, "How long will my capital last if my future investment returns do not cover my withdrawals?" In the specific example cited above, the answer is somewhere around 10-12 years before they are flat broke, perhaps a few years more if their returns are above average, or a few years less if below average.

How Long Will My Capital Last? The table below can be used to make a rough estimation of how long you can expect your capital to last. These are, of course, rough estimates only and your actual outcome may or may not vary considerably

There are three basic factors that will determine how long your capital will last: 1) The amount of capital you have, 2) your investment returns, and 3) the amount of money you are withdrawing from your account. The only factor you have direct control over is the third factor --- the amount of money you are withdrawing from your retirement account.

It's common sense that you will deplete your capital if your withdrawals are greater than your investment profits. The greater the deficit between withdrawals and investment profits, the faster capital is consumed. On the other hand, if your investment returns are more than your withdrawals, your capital is growing.

What Should I Do? The less you withdraw from your capital, the longer it will last. In the example used earlier, the retiree originally started with an 8% distribution rate from a $500,000 nest egg (8% on $500,000 equals $40,000). If they continue to take $40,000 per year from a reduced nest egg of $300,000, they are at a 13% distribution rate, which is unsustainable.

The impact of maintaining the same fixed dollar amount of distributions versus reducing them to a lower level is significant. With no belt tightening, they run a high risk of fully depleting their capital in 8-12 years. However, if they can reduce their annual withdrawals by a third, their capital has a good chance of lasting twice as long.

Protecting Your Nest Egg: The worst time to sell anything is when prices are low. Keep in mind that when prices are low, like now, you need to sell and consume more “units” of low priced capital to provide for fixed periodic withdrawals from your retirement account. Conversely, when prices are high, fewer “units” of capital need to be sold and consumed to provide withdrawals. High withdrawal rates from retirement accounts are the most damaging when prices are low. In contrast, reducing your withdrawal rate does the most good when prices are low.

Tough Times Call for Tough Measures: Every retiree making withdrawals from their retirement account needs to be aware of how their own personal distribution rate stacks up with the amount of capital they have. Every retiree needs to know whether or not they are potentially on a collision course with running out of capital and, if so, what changes need to be made now. Even small changes can make a big difference down the road.

If your distribution rate is 8% or higher, we recommend that you consider taking steps to reduce the distributions from your retirement account, even if only for awhile. If your distribution rate is over 10%, we strongly recommend you act now.

Reducing retirement account distributions for living expenses will entail sacrifices. However, postponing the tough measures that need to be taken now could possibly result in needing to take even tougher measures in the future. If you can’t cut back some now, how will you be able to cut back even more later on?

Any amount of belt tightening that can be done now will help preserve and extend the life of your capital. The sooner action is taken, and the more you reduce your distributions (even if only temporary), the better your chances are of repairing and replenishing your capital so it can provide for you for a greater number of years.

Preventive measures taken now won't necessarily be needed forever. If the next few years offer above average investment returns, today’s belt tightening may prove to be temporary. Nonetheless, reducing distributions from your retirement account will, in every instance, help preserve your capital and improve your financial security and well-being. ***

© 2002 Asset Allocation Advisors, Inc.