A bad market in early retirement can be devastating

Managing money during retirement is very different than managing money before retirement. During the accumulation phase, an emphasis is placed on attaining the highest returns. But when the time comes to begin withdrawing money, avoiding losses is significantly more important than achieving high returns -- especially during the early years of retirement.

Even if you can predict the rate of inflation and average return of your investments over the long term, encountering a bear market within the first five years of retirement can significantly increase the risk of running out of money. The accompanying chart depicts how two similar retirement portfolios performed in two different market environments over a 10-year period.

The individual in Portfolio A retires with $500,000 and earns an annual return of 9.5 percent over the next 10 years. During this period he withdraws 7 percent ($35,000) of his principal in year one, then increases his withdrawals by 3.5 percent each year thereafter for inflation. After withdrawing nearly $400,000 of income during the 10-year period, he has $697,818 in retirement savings -- more than the total with which he started.

Portfolio B shows what would have happened if our retiree withdrew the same amount of inflation-adjusted income and earned the same 9.5 percent over the same 10-year period -- but in a vastly different environment. Unfortunately for him, instead of seeing his savings gain 10 percent in year one, they lost 22.1 percent. That, combined with his $35,000 withdrawal, left him with a balance of $362,235.

Similarly, in year two, in addition to withdrawing $35,900 of inflation-adjusted income, the market proceeds to lose an additional 11.9 percent. Thus, our retiree's savings are further reduced to $287,368. And after losing 9.1 percent of his savings in year three, our retiree now has a total of just $227,466.

In other words after just three years, our fictitious retiree would have less than half of his original $500,000 savings left -- even though he only withdrew about $110,000 of income. And even though his retirement portfolio proceeded to earn an average annual return of 22 percent over the next seven years, he would still have just $266,598, compared to $697,818 in portfolio A.

You could spend as much time in retirement as you have spent saving for it. That is why planning for your retirement savings to generate income is critical. Developing a solid plan and appropriate investments for years of income are well worth your efforts.