How To Prevent A Stock Market Crash From Ruining Your Retirement

Following the pension freedoms reforms in 2015 and the introduction of Flexi Access Drawdown, the ability to take as much income as you like or change your income from year to year depending on your needs can be an appealing option for those in or on the cusp of retirement. 

However, with drawdown, the remaining pension that is not taken as income is usually invested and so there is an onus on you to manage the invested portfolio and navigate any potential bear markets or volatility in financial markets.

There are several things you can do to try and prevent a stock market crash or period of low returns from ruining your retirement. This includes things like; investing in a diversified portfolio across different asset classes and geographies. Secondly you can try and use a sustainable withdrawal rate to give you a framework for calculating how much income you might be able to take without running out of money based on historical events. Finally if you do retire just before a stock market crash, you can consider delaying retirement or keeping a years worth of income in cash so you can draw down on these funds rather than take an income from your falling portfolio.  

Why stock market returns matter for your retirement?

One of the biggest risks to the success of your retirement and not running out of money is something called the sequence of returns risk. In layman’s terms this is the idea that if you retire just before a stock market crash or a period of negative investment returns, this can have an adverse effect on the sustainability of your retirement pot compared to someone who enjoyed stellar investment returns after retiring which helps to offset any withdrawals or income payments.  

Let’s look at an example and my favourite period in history to illustrate this, the great depression. Now I must stress that this kind of period of returns in unlikely but who knows as back then there was no central bank bailing out the stock market as there is today and the data going back that far is not as accurate as it is today.    

From 1929 to the end of 1932, the US stock market lost approximately 85% of it’s value:

A £100 investment at the beginning of 1928 would have risen to £143 before falling to £50 at the end of 1932 and this savage bear market. Had you have taken a modest amount of income each year from this falling retirement portfolio, then you don’t need me to tell you this would have put a further dent in the value of the investment account.  

Now I’m not just a scaremonger and now we know what the sequence of return risk actually is, what can you potentially do to offset this risk if you are in retirement or on the cusp of retiring? 

Option 1 – Invest in a diversified portfolio

The examples of the great depression earlier were based on an all equity portfolio. Equities have the potential for large returns and have historically rewarded long term investors, but they can be extremely volatile from year to year. To prevent a stock market crash ruining your retirement, one option you could consider is diversifying across other classes such as high quality bonds, which can act as a flight to safety during times of panic.

If we look at the same period from 1928 to 1932 in which US stocks were ravaged, you can see how treasuries, US government bonds, experienced a positive return!

You aren’t just limited to US stocks and bonds either, there are many other asset classes you can potentially turn to such as gold, short term bonds, international stocks and cash as you can see in this chart which looks at the best and worst performing asset classes from year to year  

There is no guarantee that the correlation between stocks and bonds is a guarantee, that is stocks down bonds up, as both asset classes were hammered during following the war in Ukraine, but even then, you could look at short duration bonds which held up much better. 

Option 2 – Use a withdrawal strategy

If you accept that volatility within an investment portfolio is certain and it’s very likely that you will experience a number of bear markets during an investment horizon of 30 plus years, one option to negate this risk of a stock market crash ruining your retirement, is to use a withdrawal strategy to ensure you are taking a sensible and sustainable amount of income from your portfolio.

One common method is a static withdrawal rate such as 4%. This is commonly referred to as the 4% rule, and was centred around Financial Planner William Bengin research, who found that in a study from 1926 through to 1976, during some of the savage bear markets, no historical case existed during this period in which a 4% annual withdrawal rate would have exhausted a retirement portfolio over a retirement of 33 years or less. Now this is not to say 4% is the figure to go with, as even Bengin said you could potentially take more than this, whilst others would say 3% is a more appropriate figure.

The idea is that at least being aware of how much income you are taking is a good starting point. One of the most troubling studies I have seen is by the FCA which found that the average retiree in drawdown was withdrawing over 8% of their pension. If these figures are correct, which I would highly doubt are sustainable over the longer term, then retirees may unknowingly be walking into a retirement crisis as the state pension alone may not be enough for many people.  

The trouble with using a static withdrawal rate blindly is that it doesn’t react to changing environments, so if market returns are positive perhaps it is ok to take more income to reflect the increase in your portfolios value. Equally, if returns are poor over a protracted period, it may make be prudent to reduce your income.

I’ve recently made a video on this which is called the guardrails approach. This was founded by Jonathan Guyon and William Killinger. Essentially their approach is that if your portfolio increases or reduces by more than 20%, you can adjust the starting  income upwards or downwards by 10%. Guyton calculated that the maximum initial safe withdrawal rate for this period was 5.80% for a portfolio made up of 65% equities, which increased to a whopping 6.20% initial withdrawal rate for a portfolio made up of 80% equities.

Option 3 – Keep a years worth of income in cash

If you are concerned about retiring just before a stock market crash or even during your retirement, one option to consider is keeping a years worth of  income in cash either within your retirement account or in your personal savings account.

The benefits of this are that if the proverbial does hit the fan, rather than drawing down on a falling investment portfolio, you could access your cash based savings instead and hopefully wait until your invested funds have recovered. With interest rates at record levels, it’s also possible to lock in some very attractive interest rates.  

If we look at a portfolio made up of 50% US stocks and 50% 10 year US Treasuries, if we look at some of the past bear markets and drawdowns, we can see how long it takes for this portfolio to have recovered in the past:

Had you had a year or two years worth of income in cash, you could turn off the income from your retirement portfolio and draw the income from your savings in the hope that you can whether the storm and your portfolio can recover somewhat of it’s value.  

Again, who knows how things will play out in the future, past performance is no guide to the future and there is no guarantee that future bear markets will not be much worse and protracted. It also has to be said that historically at least, cash returns have been lower than traditional asset classes and even inflation, so having an outsized weighting to cash could be a drag on your future returns and actually erode the real value of your savings.     

Option 4 – Delay retirement

Another option which may not be very popular if a stock market crash does happen on the eve of your retirement, during your retirement or even if you simply don’t think you have enough to retire, would be to delay retirement altogether or work part time.

This will of course depend on many factors such as how much income you plan on taking, your other retirement income streams and how long your retirement is estimated to be, which I accept is a how long is a piece of string exercise. If you were however to go down this route, the benefits of this would be two fold, you would perhaps give your portfolio a chance to recover, you would be taking less income and may even increase your pension with further contributions. 

The value of investments and any income from them can fall as well as rise, and you may not get back the original amount invested. Past performance is not a guide to the future. HM Revenue and Customs practice and the law relating to taxation are complex and subject to individual circumstances and changes which cannot be foreseen.