A solid retirement plan doesn’t assume your financial situation and lifestyle will remain stagnant.
When you retire, monthly expenses will likely change, your portfolio may fluctuate when it’s time to withdraw and healthcare costs could keep climbing. Planning for a "bad year" can help you determine if you can withstand multiple obstacles.
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Why some retirement plans fall apart
Often, a retirement plan works until projected returns and inflation run contrary to what retirees had expected. Inflation can suddenly spike and require higher withdrawals. That can coincide with a market correction, which would force retirees to sell more of their shares to keep up with the same bills.
While rules of thumb can help, retirees’ situations can differ greatly from year to year. Some years come with 20% market downturns, while other years produce returns above 20%. What makes a year “bad” will vary from one retiree to the next, but it can include a bear market, unexpected medical bills, home repairs, high inflation or losing some income, such as a part-time gig.
It may not be fun to plan for bad years, but it is necessary.
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What belongs in a 'bad year' plan
A cash buffer is essential for a “bad” year since it can help make you less reliant on selling investments during market corrections. Many financial advisors say that retirees should have enough cash to cover a year or even two of living expenses. Consider the gap between income streams like Social Security and your monthly expenses when calculating how much of a cash buffer you need.
You may also want to create spending tiers that distinguish needs and wants. For instance, you can cut back on travel and dining out if you have a bad year, but you can’t stop paying your utilities bill. Reducing expenses in any way you can will cut down how much you must withdraw from your portfolio to stay afloat. Fewer portfolio withdrawals can minimize the long-term impact a correction can have on your net worth.
Doing some extra gig work during a bad year can provide an additional income backstop, on top of Social Security, pensions, annuities and any other income sources. Homeowners may even want to consider tapping into a portion of their home equity — though that comes with added risk, and is a move you should consider carefully.
You will also have to plan around taxes, and, depending on your age, minimum distributions (RMDs).
How to test your plan before retirement
Testing your plan before retirement can help you determine if retiring makes sense for you right now. Start by assessing how your plan would change if your portfolio suddenly dropped by 20% and inflation ran hotter than expected. You should also consider how your nest egg would change if you needed to cover an emergency expense.
You can review current spending habits to see what costs are essential and which ones you can cut. This information can help you establish a more flexible retirement date. Working a few more months can bolster your cash buffer so you can avoid selling stocks for more than a year if needed. All of this information will also indicate the best time to tap into Social Security benefits, which significantly affects your guaranteed income over time.
You don’t need the perfect plan. You just need to be prepared, monitor your finances and make adjustments along the way.
