Selling investments with losses to pay for living expenses can chew years off your retirement plan. Say you retired in 2007 at 65 with a $500,000 retirement portfolio.
Estimating an average annual return of 7% (with a 3% inflation rate), you figured your nest egg would provide $23,300 of annual retirement income for 30 years. In 2008, the S&P 500 index fell 37%. If your portfolio dropped the same amount, it would have decreased to $315,000. If you kept withdrawing $23,300 a year anyway, you’d run out of money when you reached age 80. (To keep the money going for 30 years, you’d have to decrease your annual withdrawal to $14,700.) However, in 2009, the S&P 500 went up 26.5%. That would put your portfolio at $398,475. Your plan wouldn’t be completely back on track, but it would be a lot closer.
To avoid those planning problems, create a cash reserve of low-risk low-return investments like savings accounts, money market accounts, certificates of deposit, and short-term bonds. How much cash insulation you need depends on your other sources of retirement income. If you have a pension plan and Social Security benefits that pay for most of your annual retirement living expenses, you can keep a modest cash reserve, one that covers any other expenses for a couple of years. But if your portfolio is your only source of income, having a robust five year’s worth of expenses in a cash reserve means you probably won’t have to sell investments at a significant loss.
Learn more about this topic from Personal Investing: The Missing Manual.
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