When it comes to retirement planning, timing can play an important role. A market crash (when stock prices fall dramatically) in the early years of retirement may significantly impact retirement savings. This article explores how looking at past market crashes can provide insights to help consider financial plans, explore potential protection strategies, and understand how plans might perform in challenging scenarios.
The Retirement Vulnerability Window
Retirement savings often face substantial challenges during market downturns (when investment values fall significantly). Studies suggest that the timing and order of investment returns—particularly in the first ten years of retirement—may significantly affect how long savings last. This timing can be more impactful than the average returns earned over the entire retirement period or total lifetime investment gains.
According to a study by financial expert Michael Kitces, CFP, two retirees who start with the same amount of savings and withdraw the same percentage each year can end up with very different results based solely on whether they retire just before a market downturn or during a strong market period.[1] This timing challenge, known as "sequence of returns risk," is one of the biggest threats to having your money last throughout retirement.
A landmark study by Wade Pfau, Ph.D., CFA, found that negative returns in the first five years of retirement can reduce a portfolio's sustainable withdrawal rate by as much as 1.0-1.5%.[2] For a $1 million portfolio, this represents a difference of $10,000-$15,000 less in annual retirement income.
The Historical Evidence
Historical market data provides valuable insights into how retirement portfolios have performed during past crashes:
| Market Event | Period | S&P 500 Decline | Recovery Time |
|---|---|---|---|
| Great Depression | 1929-1932 | -86% | 25 years |
| Black Monday | 1987 | -22% in one day | 2 years |
| Dot-com Bubble | 2000-2002 | -49% | 7 years |
| Great Recession | 2007-2009 | -57% | 5.5 years |
| COVID-19 Crash | 2020 | -34% | 5 months |
Source: S&P Dow Jones Indices
According to research from T. Rowe Price, a portfolio that experiences a 20% market decline in the first two years of retirement has a 31% higher probability of running out of money compared to one that doesn't face early losses, assuming a 4% withdrawal rate.[4]
The Value of Historical Backtesting
Historical backtesting can be thought of as a way to explore how retirement strategies might have performed during past market events, including during major market crashes and economic challenges. This approach may offer some advantages compared to calculators that use average returns or random simulations:
- Real-world conditions: Instead of using theoretical numbers, backtesting shows how your plan would have performed during actual historical events, including real market returns, inflation rates, and economic conditions that really happened.
- Market relationships: During market crises, different types of investments often fall together - for example, stocks and bonds might both decline at the same time, making it harder to protect your portfolio. Backtesting captures these real-world relationships that simple calculators might miss.
- Worst-case scenarios: By including major market crashes like the Great Depression of the 1930s or the 2008 financial crisis, backtesting helps you understand if your retirement plan could survive similar severe market downturns in the future.
Expert Perspectives on Backtesting
Experts acknowledge the utility of backtesting for providing a historical perspective, but caution against relying on it exclusively.[6]
- Portfolio Analysis: Backtesting is used to determine suitable safe withdrawal rates and analyze portfolio performance across different market conditions.[7]
- Future Returns: However, some experts warn against over-reliance on historical data, especially with potentially lower future returns in current market conditions.[8]
- Planning Limitations: Concerns exist that it can lead to overly conservative plans or fail to account for the complexities of real-world markets and investor behavior.[9]
Current research suggests that backtesting should be used as one tool among many for gaining historical perspective, but not the sole determinant in retirement planning.[10]
Understanding Backtesting Limitations
While backtesting offers valuable insights, understanding its limitations is equally important for balanced retirement planning:
- Evolving market dynamics: Financial markets are constantly changing, influenced by factors that may not repeat in the same patterns. Research indicates that strategies that performed well in past conditions may not generalize to future market environments.[11]
- Black swan events: Rare, unpredictable, and high-impact events that can fundamentally alter market dynamics may not be reflected in historical data.[12]
- Survivor bias: Historical datasets often include only companies and funds that have survived to the present day, potentially leading to an overestimation of returns.[13]
Strategies to Consider for Retirement Planning
By studying how different retirement strategies performed during past market crashes, research has identified several potential approaches that may help protect retirement savings:
1. Keep a Cash Safety Net
A Morningstar study suggests that maintaining 2-3 years of living expenses in cash (such as in a savings account) might help improve portfolio longevity in retirement. The potential benefit comes from having cash available for spending during market downturns, possibly reducing the need to sell investments when values are lower.[14] Historical data indicates this approach could have provided some protection during past market downturns, though individual results may vary based on specific circumstances.
2. Flexible Spending Considerations
An approach called "Guardrails," researched by Jonathan Guyton and William Klinger, considers adjusting withdrawal amounts based on investment performance[15]. A study in the Journal of Financial Planning observed that retirees who were able to reduce their optional spending by 10-25% during market downturns had more sustainable retirement outcomes - as seen during periods like the high-inflation environment of 1966-1982.[16] This strategy is like tightening your belt temporarily during tough times to ensure your savings last longer.
3. A Portfolio Segmentation Approach
One way to think about organizing retirement funds is like having separate accounts for different timeframes: one for near-term expenses (such as the next 1-2 years), another for the medium term (3-7 years), and one for longer-term growth (8+ years). Studies indicate this approach may have helped some retirees navigate through market downturns like those in 2000-2002 and 2007-2009 compared to other methods of managing retirement money.[17] This way, you're not forced to sell long-term investments when markets are down.
4. Considering Different Investment Types
Research by David Swensen at Yale suggests that considering additional investment types - such as real estate investment trusts (REITs) and inflation-protected securities (TIPS) - alongside traditional stocks and bonds might offer another way to approach market downturns.[18] This is like not putting all your eggs in one basket, making your retirement savings more resilient to different types of market conditions.
Free Tools to Test Your Retirement Plan
Several free online tools can help you check if your retirement plan is strong enough to handle market crashes. Each tool has different strengths:
FIRECalc - Great for Historical Stress Testing
FIRECalc FIRECalc evaluates your retirement strategy by analyzing how it would have performed across every year since 1871, including periods like the Great Depression and major market downturns. By inputting your savings, spending, and retirement timeline, it simulates your plan's success rate under historical market conditions. While the interface is straightforward, the depth of historical analysis makes it a powerful tool for both novice and experienced planners.
FI Calc - Best for Withdrawal Strategy Planning
FI Calc FI Calc offers a clean interface with advanced features for modeling retirement scenarios. It supports various withdrawal strategies, including Constant Dollar, Percent of Portfolio, VPW, Guyton-Klinger, and Vanguard Dynamic Spending. Users can input detailed income streams and expense patterns to reflect real-life finances. The tool allows for portfolio customization, including asset allocation adjustments and rebalancing frequencies. Despite its simplicity, FI Calc provides depth and flexibility for comprehensive retirement planning.
Portfolio Visualizer - Best for Deep Investment Analysis
Portfolio Visualizer This tool offers institutional-grade analytics, including Monte Carlo simulations, factor analysis, portfolio optimization, and historical asset correlations. Portfolio Visualizer is ideal for those wanting to dive deep into asset allocation, rebalancing strategies, or risk-return tradeoffs. Though it may appear complex, it’s one of the most comprehensive tools available to retail investors.
NumberWalk - Best for Spending and Market Behavior
NumberWalk NumberWalk offers a comprehensive approach to retirement planning by modeling both pre-retirement savings and post-retirement spending. It accounts for variable expenses, such as healthcare inflation, irregular costs, and ongoing commitments like loans or education fees. The tool allows users to simulate different investment returns, adjust asset allocations over time, and incorporate additional income sources like rentals or part-time work. NumberWalk emphasizes user privacy. This makes it an ideal choice for individuals seeking a realistic and private retirement planning experience.
Retirement Planning Tools at a Glance
| Tool | Best For | Complexity | Key Feature |
|---|---|---|---|
| FIRECalc | Beginners | Low | Historical data since 1871 |
| FI Calc | Withdrawal strategies | Medium | Comprehensive withdrawal strategies |
| Portfolio Visualizer | Investment deep dive | High | Professional-level portfolio analytics |
| NumberWalk | Real-life flexibility | Medium | Dynamic and Adaptive spending |
Testing across multiple tools provides the most complete picture of your retirement readiness.
Professional-grade tools excel at investment analysis and portfolio optimization, while retiree-developed tools often better reflect the real-world spending adjustments we make in response to market conditions.
The Psychological Impact of Market Downturns
The effect of market crashes on retirement extends beyond pure mathematics. Research shows that retirees facing market downturns early in retirement often experience significant psychological pressure that can lead to emotionally-driven decisions with long-term consequences.[19]
Common reactions include selling investments at market lows (locking in losses), drastically cutting spending beyond what's necessary, and losing confidence in otherwise sound retirement strategies. Working with a financial advisor can provide the behavioral coaching necessary to avoid emotional decisions that compromise long-term security.
Beyond Historical Data: Forward-Looking Considerations
While historical backtesting provides valuable insights, research suggests that expected future returns for traditional asset classes may be lower than historical averages.[20] A comprehensive retirement plan should incorporate both historical lessons and forward-looking analysis that accounts for:
- Current market valuations and their potential impact on future returns
- Demographic shifts influencing markets and economies
- Structural economic changes that may affect traditional asset class behavior
Reflecting on Historical Insights
While past performance doesn't guarantee future results, historical backtesting may provide useful perspectives on how different retirement strategies respond to market stress. A Vanguard study suggests that examining plans through historical bear markets could help develop realistic expectations and inform decisions about potential withdrawal approaches.[22]
Looking at how different strategies performed during periods like the Great Depression, the stagflation of the 1970s, or the financial crisis of 2008-2009 might offer insights for building retirement plans that can adapt to various market conditions.
In his paper "The Retirement Calculator from Hell," Bernstein suggests that while considering challenging scenarios might mean accepting lower returns in some cases, it could help protect against significant setbacks in retirement planning.[23]
As markets continue to evolve with their inherent volatility and uncertainties, combining historical analysis with flexible spending approaches represents one way to think about retirement planning. Each person's situation is unique, and working with financial professionals can help develop strategies tailored to individual circumstances.