Imagine you've made it to retirement and all that means. No more day job. The extra time to do the things you previously could only do while you were on vacation. Not that you necessarily would pass all your retirement doing those kinds of things, but if you wanted to, you certainly could do a lot more of them than you could when you were working.

There is a catch. Your retirement savings have to last as long as you do after you stop working. That means they will have to weather through things like the stock market's volatility. Volatility that could potentially deliver a hit to your retirement savings.

There's no telling when such a hit to your financial security in retirement might happen, but if you live long enough, chances are you will experience that kind of drama. If you were to take that kind of hit, when do you think it would be best for you to handle it? Early in your retirement when you might have more time to recover from it? Or later?

In other words, when is the worst time to take a hit to your retirement savings and your plans for how you'll live when you're retired?

Analysts at Charles Schwab's Center for Financial Research took on that question. Their answer is visually presented in the following chart for hypothetical investors who start their retirements with the same amount of savings and the same plan of taking $50,000 annual withdrawals that escalate by 2% a year for inflation all throughout their retirement.

The difference between the two scenarios for Investor 1 and Investor 2 is the timing for when their retirement savings takes a big hit. Investor 1 experiences a -15% annual return during each of the first two years of their retirement, while Investor 2 has to deal with the same magnitude hit in their tenth and eleventh year of retirement. Their investments otherwise perform similarly [1].

As the chart reveals, Investor 1 runs out of money in Year 18 of their retirement. Investor 2 however still has quite a lot of their retirement savings left at the same point of time. It is far worse to experience a major hit early in retirement.

Of course, that assumes that neither hypothetical investors ever changes how much they withdraw each year from their retirement savings after taking the big hits they do, which is a different topic for a different day. For now, the important thing is to know that being able to sustain a big hit to your retirement investments in the first two years of your retirement savings is something for which you can and should plan. Remember, the worst case scenario is your retirement savings get knocked down right after you retire. If you don't experience that kind of event until you're well into retirement, you won't have the same risk of your retirement savings running out of money while you need them.

Schwab's Rob Williams offers a suggestion for how to handle the worst case scenario:

One approach is to maintain a short-term reserve of low-risk liquid investments that you can use to cover your expenses while you avoid tapping your stocks.

Rob recommended keeping a year's worth of expenses after accounting for other income sources including Social Security, if applicable, in cash investments and another two to four years' worth of expenses in high-quality short-term bonds or short-term bond funds. This allocation can be included as part of your retirement portfolio. A portfolio in retirement can include a personalized mix of cash, cash investments, short-term and other types of bonds or bond funds, and stocks. With an allocation to cash, cash investments, and short-term bonds in place, you may feel more comfortable about having a decent chunk of stocks on hand that can generate growth later.

There are a lot of ways allocate funds to function as a relatively safe reserve and there's not by any means a one-size fits all way to do it. Setting up such a stormy weather reserve as part of your retirement plan can give you a better ability to handle a major market downturn by helping you avoid having to otherwise deplete your retirement accounts too quickly to pay your living expenses in retirement.

Notes

[1] Here's the fine print from Schwab's hypothetical investing scenario for the two investors:

The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product. Dividends and interest are assumed to have been reinvested, and the example does not reflect the effects of taxes or fees. Both hypothetical investors had a starting balance of $1 million, took an initial withdrawal of $50,000, and increased withdrawals 2% annually to account for inflation. Investor 1's portfolio assumes a negative 15% return for the first two years and a 6% return for years 3 – 18. Investor 2's portfolio assumes a 6% return for the first nine years, a negative 15% return for years 10 and 11, and a 6% return for years 12 – 18.

Image credit: Worst Case Scenario Chalkboard by Nick Youngson. Creative Commons CC BY-SA 3.0 at Picpedia.org.