by Mark Miller

photo by Nicola Barts

If you're not close to retirement age, stay the course.

If you're about to retire or already retired, the choices are tougher—but that doesn't mean you're helpless.

I believe firmly that retirement savers need to hang on tight through the stomach-churning roller coaster of a bear market. Unless you think we’re witnessing the end of the free enterprise system as we know it—and I don’t—selling in a panic is the worst mistake you can make.

But staying the course for long-term gain is a lot easier for younger retirement savers, who don’t need to tap their 401(k) accounts for some years to come. For anyone who’s retired recently—or is very close to retirement—the questions are much more difficult.

Unfortunately, many of these folks appear to have been far too aggressive in the amount of equities they’ve held approaching retirement. According to the Employee Benefit Research Institute, 38 percent of 401(k) investors age 56 to 65 had more than 80 percent of their portfolios in equities as recently as 2006. Most financial planning pros advise reducing exposure to stocks as retirement approaches, to somewhere around 50 or 60 percent.

But that doesn’t mean you’re helpless if you retired recently and have been hammered by the bear market in stocks, or if you need to retire soon. Smart strategic options are available to you—although they’re not painless.

The key is maintaining a long-term perspective, because the goal here is to make sure your retirement nest egg lasts many years into the future. So, the question isn’t really what your portfolio looks like today—but how you’ll manage it over what could be a 30-year period, assuming today’s longevity rates.

T. Rowe Price recently analyzed possible outcomes for investors who had the bad fortune to retire into a bear market. The investment management company did a Monte Carlo probability analysis to determine which investment management decisions would allow investors to stretch their nest egg savings over a 30-year retirement.

The analysis looked at 10,000 simulated portfolio outcomes using actual stock performance data from 2000 to 2002—a bear market during which the S&P 500 fell 42 percent. The analysis assumed a tax-deferred portfolio invested 55 percent in equities and 45 percent in bonds.

Here’s what they found:

The worst decision you can make: Sell off all your stocks at the market bottom and switch to an all-bond portfolio. With this emotion-driven approach, there is only a 5 percent chance that your retirement nest egg will last 30 years, according to the probability analysis. Not only do you suffer the losses of selling at the bottom, but with your money in bonds you miss out on the growth from equity investments when the market rebounds, and all the successive rallies that follow in succeeding decades.

The best decision you can make: Don’t sell. Instead, adjust your plans for withdrawing funds—especially in the early years of retirement. Most financial advisors advise withdrawing 4 percent of a nest egg balance in the first year of retirement, and increasing annual withdrawals by 3 percent annually to keep pace with inflation.

But in one of T. Rowe Price’s hypothetical scenarios, the retiree holds off on taking any inflation adjustments for several years, until the market rebounds. That decision has a huge, positive impact on portfolio longevity; in fact, it yields an 89 percent probability that the retiree’s funds will last 30 years.

In a much more aggressive hypothetical, T. Rowe Price assumes that the retiree reduces planned withdrawals by 25 percent. That restores a 99 percent probability that the funds will last 30 years—but it’s too draconian a cut for most people. Still, it does illustrate the potential available to you in holding back on withdrawals. (One caveat: Since tax-deferred accounts require that you take minimum distributions starting at age 70-1/2, T. Rowe price assumed that these distributions are reinvested in taxable equity accounts.)

No doubt, these scenarios represent belt-tightening. After all, we’re talking about a bear market. But remember—the main objective is to maintain your nest egg to support a long life. And T. Rowe Price Senior Financial Planner Christine Fahlund—who did the analysis—points out that cutting back on spending in early retirement is feasible for many. “It works best if you can start with discretionary items, especially big-ticket expenditures. Don’t redo the kitchen, or don’t buy a new car.”

Another important option to consider is putting off retirement or going back to work, if that’s an option. I’ve written frequently about the many benefits of working past the minimum retirement age—as defined by Social Security rules—of 62. Among others, working a few additional years most likely will fatten up your Social Security payments considerably over a lifetime, as the rules generally are written to penalize people who file for benefits early.

Just as important, every year you work is a year you won’t be drawing down any 401(k) savings; instead, you’ll be making payroll contributions to your plan and buying stocks at bargain, bear-market rates. Those investments will pay off down the road when you retire and the market rebounds.

T. Rowe Price estimates that working until age 65 will boost annual retirement income from investments by 28 percent.

“If you have the choice, remain flexible on your retirement timing,” advises Fahlund. “It’s inadvisable to retire into a market like this, because you start withdrawing from a portfolio that’s down, which makes matters worse. If you think you can hang on a few more years, wait a bit longer and pump up your 401(k) contributions. The markets will rebound and you will have bought more shares at the low end.”

© 2008 Tribune Media Services Inc.