Market Setbacks Don’t Need to Set Back Your Retirement Plans

Late last year, in our 2022 U.S. Retirement Market Outlook, we expressed our concern that investment returns might be lower over the next several years than they have been historically. Little did we know that our concerns would materialize so fast. In the first half of 2022, the S&P 500 Index dropped 21%. For those of us involved in retirement planning, the recent volatility begs the question of whether—and how—retirement savers should react.

We address this question by revisiting our retirement saving guidance, particularly, our suggested saving rate of 15% (including employer contributions) and age‑ and income‑specific savings benchmarks. We also outline possible strategies for workers and retirees to adapt to the current market conditions.

To track the progress of retirement savers, T. Rowe Price publishes age‑ and income‑specific savings benchmarks.¹ These are approximations of how much someone should have saved by a given age and level of income to have sustainable replacement income in retirement. For the calculation of these savings benchmarks, we assume an average annual return of 7%. This assumption is based on historical returns of different asset classes and age‑based portfolio allocations.

But in lower expected return environments, should those saving for retirement assume lower returns and save more? To answer this question, we explored a hypothetical alternative retirement savings benchmark.

The hypothetical alternative savings benchmark assumes 4% returns for five‑years, which we consider the mid‑term, and then reverts to 7% after that.

Under the lower midterm return assumptions, our age‑specific savings benchmarks are unchanged for workers under age 50. In our view, these workers have enough time left to recover from any short-term to midterm market turmoil and need not focus on short‑term market returns if they are on track to reach these benchmarks.

For those between ages 50 and 65, there are slight increases in the benchmarks (as highlighted above). Because these savers have a shorter investment horizon left, they have less time to recoup lower returns. Also, by the nature of compounding, the final years before retirement usually yield the highest portfolio returns in absolute (or dollar) terms (and not necessarily on a percentage basis). If returns are muted during this period, then savers will need to make up that ground by increasing their savings.

For those close to retirement but unable to meet the adjusted benchmarks, there may be other options to consider. They might consider delaying retirement for a year or two, taking up some part‑time work in retirement, or making some spending adjustments. We suggest these individuals work with their financial professional to assess options and craft a plan that works best for their personal situation.

A good rule of thumb is that workers save at least 15% (including any employer contributions) of their annual salary for retirement. This is a rule of thumb; in practice, the suggested savings rate will vary from person to person, usually increasing for people with higher incomes.

To answer this question, we looked at the behavior of 401(k) participants during the first half of 2022 (January 1–June 30) from T. Rowe Price’s recordkeeping data. Using collective and anonymized data, we analyzed their exchange activity (switching between investments) and changes in their deferral rates during this volatile period.

In general, 401(k) participants have been staying the course. Based on our research, over 95% of 401(k) participants have not made any investment exchanges during the first half of 2022. But underlying that, there are some noticeable trends.

Apart from exchanges, 401(k) participants can also change their deferral rates in response to market conditions, but other factors may also be at work. For most of the first half of 2022, average deferral rates stayed relatively stable. More recently, though, the average has trended downward, suggesting that cutting back on contributions is one way workers may be coping with inflation at four‑decade highs. If high inflation persists and the downward trend in deferral rates is prolonged, then it could become problematic because retirement savings might fall.

Review Their Spending Expectations

Our research² indicates that a conservative withdrawal approach is an important way to navigate an uncertain market environment, especially at the onset of retirement. To gain insight on portfolio sustainability, we tested the 4% rule of thumb in three past market environments, each starting with a bear market at the onset of retirement. The 4% rule of thumb suggests that an individual withdraw 4% of their retirement portfolio in the first year of retirement. That amount is assumed to increase with inflation each year over the retirement horizon.

We assumed a beginning balance of $500,000 and an initial withdrawal amount of $20,000 in the first year (4% of the portfolio). We considered three historical time periods that begin with significant market sell‑offs: retirements beginning in 1973, 2000, and 2008. In each scenario, we considered the historical performance of a portfolio consisting of 60% stocks and 40% bonds using index data and increased the initial withdrawal amount by the actual inflation rate³ at that time to maintain purchasing power.

We found that each scenario was able to support portfolio withdrawals and projected withdrawal amounts throughout each retirement horizon. Additionally, in all three scenarios, the remaining portfolio balance was above the starting portfolio balance ($500,000) as of the latest available date and age profile. So, a conservative spending approach can not only make the portfolio sustainable, but it may also preserve assets, which is generally a key financial goal for retirees.

While this analysis is encouraging and the 4% initial withdrawal guideline may be a reasonable rule of thumb for those who are years away from retirement, investors closer to and in retirement need to consider their specific circumstances and retirement budget.

We have also examined actual spending patterns in retirement⁴ and found that, on average, inflation‑adjusted spending declines by 2% annually after age 65.

Additionally, we found that retirees adapt their nondiscretionary spending to their level of guaranteed income in retirement. Understanding specific spending needs to determine which expenses are essential and which are discretionary may help retirees modify their withdrawal approach.

Build Up Cash Reserves

Most people are aware of the importance of having an emergency fund in place to help them get through periods of financial shock, whether it be a loss of income or a large, unexpected expense. For workers, we suggest an amount that could cover three to six months of expenses. Having this money accessible outside of retirement accounts can help workers maintain control and weather periods of uncertainty without adding to their credit card debt or raiding their retirement savings.

When heading into retirement, we suggest a cash buffer that could cover one to two years of spending needs. Having an alternative and stable source available to fund expenses can be particularly helpful in a down market to give retirees cover until their investments rebound. Consider holding these assets in a bank savings or money market account; short‑term bond funds; short‑term certificates of deposit; or, if in a high tax bracket, tax‑free short‑term bond or money market funds.⁵ This money provides retirees access to short‑term liquidity so that they do not have to withdraw from their longer‑term investments.

Maintain an Appropriate Asset Allocation for Long‑Term Success

Asset allocation is a key driver of a portfolio’s performance over time. Allocating investments across the primary asset classes (stocks, bonds, and cash) provides an appropriate balance between short-term stability and long-term growth potential necessary for a long retirement. In general, the longer the time horizon, the more of an investor’s portfolio that should be allocated to stocks. Younger investors have the time to withstand short‑term volatility of stocks and benefit from compound growth, and stock returns have generally outpaced inflation over the long term.

As investors approach and move into retirement, adding bonds can help dampen short‑term ups and downs in the market while still providing growth opportunity. T. Rowe Price sample retirement portfolios offer a good starting point. These portfolios include ranges of the primary asset classes to accommodate investors’ risk preferences while considering allocations appropriate for various ages and time horizons.

Diversifying within each asset category is also important. For example, investors concerned with inflation risk or seeking real (inflation-adjusted) growth could look for a combination of growth‑oriented and inflation‑sensitive investments in strategic allocations within their current mutual fund portfolios, or they might seek out funds with some of these underlying investments. Assets that have generally performed well in periods of unexpected or rising inflation include real assets equities, Treasury inflation protected securities (TIPS), and higher‑yielding bonds.

Varying growth and inflation environments have tended to favor different asset classes. Our investment professionals may consider these dynamics in their underlying allocations.

Investors managing their own retirement portfolios could check that their portfolios have exposure to a range of these investments. Many other investors may find it beneficial to use professionally managed investment products, such as target date strategies with underlying actively managed components, or to work with a financial advisor on a personalized investment plan. Of course, diversification cannot assure a profit or protect against loss in a declining market and the asset classes noted are subject to varying levels of risk.