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How Does a Stock Market Crash Impact Your Financial Plan?

Posted: Jared Jameson

The recent market decline brought to light a major concern shared by many of our clients. Will my financial plan still work after a stock market decline? During our most recent conference call, we presented the preliminary results of a study we conducted to answer this question. The answer depends on the following:

  • How much you withdraw from your portfolio
  • How much the stock market declines

Study Set-Up

We assumed the following for our sample client in the study:

  • Retired
  • Age 62
  • 30-year time horizon
  • $1 million portfolio
  • Does not include other income sources (such as social security, part-time work, pension, etc.)

We tested initial portfolio withdrawal rates of:

  • 3.5% ($35,000)
  • 4% ($40,000)
  • 4.5% ($45,000)
  • 5% ($50,000)

The withdrawal rate represents the amount of money withdrawn from the portfolio in the first year. So, for example, $35,000 withdrawn from a $1,000,000 portfolio is a 3.5% withdrawal rate. We increased the withdrawal amount each year using an assumed inflation rate of 2.20%. Thus, the actual amount withdrawn rises over time.

We tested these scenarios using a moderate benchmark portfolio which is allocated 60% to global stocks and 40% to bonds.

We simulated global stock market declines of 15%, 30%, 45% and 60% occurring in the first year of the plan. Please note this does not imply that your portfolio declines by this amount as we assumed the bond portion of your portfolio remained flat during those drawdowns. Thus, the moderate benchmark decline would be 9%, 18%, 27% and 36%, respectively.

To give perspective, global stocks declined 53% in 2008 and the moderate benchmark was down 35%. This year global stocks declined 34% and the moderate benchmark was down 20%.

We also assumed returns after the decline would increase so that the long-term return, regardless of the size of the market decline, would be the same.

Withdrawal Rate’s Effect on Plan Success

The chart below shows how the probability of success goes down as the stock market decline becomes more severe. Each colored line represents a different initial withdrawal rate from a moderate portfolio.

Anything below a 65% probability of success is considered “failing” (the shaded area). Starting probabilities of success at this level or lower are subject to failure (i.e. running out of money) with only small increases in spending, slightly lower returns or a combination of the two. These plans show little margin of safety and when we encounter them, we recommend clients work longer or spend less.

First, we analyzed the results for withdrawing 3.5% annually (the green line). This line starts at a 97% success rate and declines to an 80% success rate. Therefore, taking 3.5% annually is sustainable, regardless of the stock market decline.

As the withdrawal rate increases, thus reducing the starting probability of success, declines in the market cause the subsequent changes in success rates to deteriorate more sharply than at the lower withdrawal rates.
Stock Market Decline

The 4% withdrawal rate (the pink line) starts at a 92% success rate and declines to a 55% success rate. Given how unlikely a 60% market decline is, we would conclude that taking 4% annually is prudent without having to worry about market declines and/or having to reduce spending in the future.

The 4.5% withdrawal rate (the red line) starts at an 80% success rate and declines to a 29% success rate. We consider this scenario “borderline” as a modest market decline could be absorbed, however, it is clear that a more significant decline would likely result in needing to lower spending at some point in order to avoid depleting the portfolio.

Therefore, if a withdrawal rate is greater than 4%, a stock market decline of 45% would indicate the point in which spending levels would need to be reduced temporarily to ensure the portfolio remains throughout retirement.

Changing Benchmark After a Market Crash

What happens to a financial plan’s success rate if the benchmark is changed during the market downturn? Of course, increasing the risk of the benchmark would be the best option during declines, however, we are usually asked by clients to do the opposite. Most often, clients choose to reduce risk going forward (hoping to limit their losses); however, this adjustment also reduces their future expected returns. The following chart shows this result using a typical 4.5% withdrawal rate. The dashed line represents changing from a Moderate to a Conservative portfolio after a market decline occurs.

Stock Market Decline

As the chart shows, at modest stock market declines, changing benchmarks has little impact. However, during larger declines, changing to a more conservative benchmark can dramatically reduce the probability of success going forward.

Our Conclusions:

Our analysis demonstrates that plans with acceptable, but low, probabilities of success are least able to absorb large market declines even if subsequent returns are higher. Clients that find themselves with plans in this situation should anticipate having to reduce spending if stock market/portfolio declines are large. On the other hand, clients whose plans have high probabilities of success, because of low withdrawal rates, can overcome even significant downturns without having to make changes to their spending. Finally, panicking and selling after a downturn can lock in losses and jeopardize long-term plans. It is almost always better to remain calm, stay invested and control areas you can control like spending.

Please note these results are based on our sample client. Results and outcomes will vary based on your unique situation (i.e. time horizon, other sources of income, spending level, chosen portfolio, etc.) and the timing of when market declines occur. Typically, we find that market declines have the most impact on clients who are early on in their retirement, which is the “bad timing” scenario that you may be accustomed to seeing when we review your financial plan. Please feel free to reach out to us if you would like to further discuss the potential impacts of market movements on your financial plan.

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