The idea of coming up with an exact number for how much you need to save for retirement is an attractive one for savers. By drawing a visible finish line for your retirement savings, a retirement number can be the foundation of your financial planning throughout your career.
In coming up with a good estimate for a retirement number, it's crucial to understand how having a bad market in early retirement can have a huge impact on the viability of your entire long-term retirement strategy. If you don't take this risk into account, it could pose a threat to the accuracy of the retirement number you've spent a lifetime seeking to reach.
How a bad market early in retirement can snare you
In coming up with a viable retirement number, the ideal situation is one in which you can weather the worst future conditions the financial markets can throw at you. Much of the time, planning for the worst will leave you in far better shape than you expected, as worst-case scenarios don't occur very often. Yet if you truly want a retirement number that maximizes the probability that your money will outlast you, you can't afford to ignore realistic future scenarios, no matter how improbable they might be.
In doing research on the retirement-number question, many experts have noticed that the most difficult situations retirees face occur when a major market correction occurs soon after a person retires. Even when overall average annual returns over the long run are similar, a retiree who suffers poor performance early in retirement has a much harder time preserving his assets than one who's fortunate enough to avoid bad markets until later on. Indeed, in some cases, even a retiree who has a higher average annual return in retirement still ends up worse off if the worst years come early on.
Experts call this problem sequence-of-return risk, and the problem stems from the fact that retirees need to take withdrawals from their savings in order to cover their living expenses in retirement. In simplest terms, bad performance early in retirement forces you to "sell low" by liquidating investments at fire-sale prices to cover your required withdrawals. If poor initial returns last long enough, then you won't have enough money to enjoy the full benefit of any future rebound in the financial markets.
2 ways to protect against this retirement-number risk
In response to sequence-of-returns risk, financial analysts have come up with conservative rules of thumb such as the well-known 4% rule to help savers build more secure retirement nest eggs. Using historical data that suggests a typical balanced portfolio with stocks and bonds can make it through tough market conditions for a 30-year period as long as you start out taking no more than 4% of your initial portfolio value, coming up with a retirement number is simple: Just multiply your expected annual income needs in retirement by 25.
However, there are several problems with that approach. First, many people have a hard time saving 25 times their expected net spending in retirement. Also, some believe the 4% rule could be problematic in a low-interest rate environment, because low initial bond yields leave the income-generating side of the portfolio weaker than usual.
An alternative approach uses a different way of thinking about retirement. The benefit of the 4% rule is that it aims to provide exact expectations for what you can safely spend. Yet in reality, most retirees aren't terribly comfortable continuing to spend at heightened levels when the markets move against them, and they instead look at ways to economize and spend less. Adapting the 4% rule to allow for reductions in withdrawals during lean return years is an idea that has been floating around for years, and research suggests that if a retiree can handle volatile markets by cutting spending, it can reduce the needed multiple of annual expenses from 25 down to 20 or lower.
With markets at high levels now, those who have recently retired are understandably nervous about the potential fallout from sequence-of-returns risk. Your best defense against this risk is to find ways to be more flexible with your financial needs. If you can build in some resiliency to changing future conditions, you'll be much more likely to aim at a retirement number that will get the job done.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.