A 30% Crash in Your First Year of Retirement Costs More Than 30%

A 30% drop costs more than 30%

Picture that first Monday after you retire. You don't set an alarm, and for the first time in 40 years there's no paycheck coming on Friday. Now picture the market ending that year down 30%.

The market will come back. What doesn't come back are the shares you had to sell while it was down there, because the bills didn't stop when the paycheck did. That's sequence of returns risk, and it's why the worst year to retire in American history didn't have a crash in it at all.

Put real numbers on it. You retire with $1 million and the market falls 30%, so the portfolio is worth $700,000. Say you need $40,000 a year out of it to live on. You take it, and you end the year at $660,000. A 30% drop doesn't need a 30% gain to get back to even. It needs 43%, because the gain gets calculated on $700,000 now, not on the million.

The shares are the part that never comes back

Say the market climbs all the way back to where it stood the Monday you retired. You'd have about $943,000. With no crash at all you'd have been at $960,000. Selling at the bottom cost you $17,000.

If your shares were worth $100 each, $40,000 took 400 shares. After the drop, that same $40,000 took 571 shares. You sold an extra 171 shares to pay the same bills, and those shares aren't in the account when the rebound arrives.

That assumes the market comes back before you have to take money out again. Drops of 30% or more have hit about six times since 1950, and most took years to recover. After the 2007 peak it took until March of 2013, five and a half years of pulling money out of an account that's underwater the whole time. Plan on this money lasting 25 or 30 years and expect to sit through two. That's the base case.

When the market doesn't bounce back

Somebody retires in January of 2000 with $1 million, every dollar in the S&P 500, pulling $40,000 a year with no raise for inflation. The market falls three years in a row out of the gate, and he lands at about $542,000. Four good years follow and by the end of 2006 he's back to about $716,000. Then 2008 happens and he ends that year at about $427,000. After the 2009 rebound he's at $488,000, having taken $400,000 out over the decade to live on. Bonds in the mix soften numbers like these without changing the shape of the curve.

The ending number matters because of what it does to next year's withdrawal. He's still taking $40,000. Out of $488,000, that's over 8% a year. He started at 4% and didn't change one thing about his lifestyle. The math changed underneath him, and a rate like that usually doesn't hold up for another 20 years. He came out okay, because the 2010s turned into one of the greatest runs in market history, which he had no way of predicting in 2010.

I remember how tough those years were. My dad was building spec houses and got caught holding a couple of them when the market turned in 2008, and it bankrupted him. He didn't get to choose when he sold them or for how much.

The worst year to retire wasn't a crash year

The planner Michael Kitces took every retirement start year on record and asked whether early returns predicted what a retiree could safely spend over 30 years. The first 12 months barely predicts anything. The first 10 years predicted most of it. The worst first year on record is a 42% drop, and someone who retired into it could still have spent 5.3% a year for 30 years. That's more than the 4% rule allows.

The worst year to retire was 1966, when a retiree could safely spend only about 4.1% a year, the lowest on record, including the Great Depression. Nothing crashed that year. The market went nowhere for a long time and everything got more expensive. From 1966 through 1982 the S&P 500 was up 204% with every dividend reinvested, and consumer prices were up 206%.

For a retiree that's worse than a wash, because withdrawals climbed along with prices. The 1966 retiree who started out taking $40,000 a year was taking about $115,000 by 1982. Same house, same groceries, nearly triple the money to buy them, out of a portfolio that went nowhere.

Three things decide what a bad year costs you

What decides your retirement is whether a drop forces you to sell. The first of the three is where the next two or three years of spending comes from. On $40,000 a year of withdrawals, keep $80,000 to $120,000 out of stocks entirely. High yield savings, T-bills, short-term bonds, somewhere the principal won't drop in a crash but still earns a little. An asset that falls 30% alongside your stocks does you no good in the year you need it. People call this the bucket strategy, and the label isn't what matters. Cash on the sidelines is. It covers the worst stretch, and you refill it when the market's back.

The second is cutting withdrawals in the years the market drops. I know how that sounds when you're already down. Skip the inflation raise or take about 10% less. On $40,000 you're taking $36,000, and two years of that leaves roughly $8,000 of shares invested at the worst prices in the cycle. Vanguard has a version with guardrails, where you recalculate spending each year off the actual balance, never letting it rise more than 5% or fall more than 2.5%. That's a softer trim, and the trade is less protection in exchange for never making the call in the moment.

The third is income that shows up without you selling anything. Social Security, a pension if you have one, dividends, interest, rental income. Back to that $40,000 of expenses. If $30,000 of it arrives as income, the crash-year sale drops to $10,000, and the permanent damage shrinks along with it. The first two get you through a bad year without selling at the bottom. This one leaves less to sell at all.

You're replacing a paycheck

None of this is a problem while you're still working, because the mortgage gets paid on Friday either way. When the paycheck stops, most people don't change anything. The same portfolio sits there, but it has a new job now, and the job is buying the groceries. That's what turns a bad year into a permanent loss.

Moving part of your portfolio into things that pay you brings back what the paycheck was doing. Dividend stocks pay you while you keep the shares, though the value moves. High yield savings and CDs are safer and pay less. Bond ladders have rungs coming due every year. Rental property means being a landlord.

Then there are private mortgage notes. Normally somebody buys a house, goes to a bank for a loan, and the bank collects a payment every month for years. A private mortgage note is that arrangement with an individual lending the money instead of the bank. One loan on one house, secured by a first position lien recorded at the county, so if the payments stop, the note holder is first in line against the property. These can be held inside a retirement account through a self-directed IRA custodian.

You don't get to pick what the stock market does in the year you retire. What you can pick is where that year's grocery money comes from, and whether a bad year forces your hand.