Courtesy of Devin Peterson, RICP, Advisor
The 20-yard line looks like any other line on the football field, but the game changes as soon as the offense crosses it. This is the Red Zone, the 20 yards left before reaching the end zone. Here, defensive players change their tactics and play with heightened awareness—closer to the line of scrimmage with tighter coverage on the receivers to protect the end zone.
There’s another red zone off the field and closer to home: the Retirement Danger Zone. Here, the financial game transforms, and your defenses need to be stronger and more secure to protect yourself during the few years before and after your retirement date. In this article, we’ll discuss the Retirement Danger Zone, how sequence-of-return risk factors into your financial strategy, and how to protect yourself to come out ahead.
What is the Retirement Danger Zone?
The Retirement Danger Zone covers the period five years before and five years after retirement. You could be getting ready to retire, with plans to leave your employer, or you could be a few years into your retirement and collecting social security. No matter where you fall in this window, you need to be aware of your financial vulnerability.
During this 10-year period, your retirement assets are most vulnerable to market losses, so they need more protection. This vulnerability is caused by the common need for retirees to take withdrawals to supplement their other sources of retirement income. Traditional wisdom for using a market portfolio to supplement your income is withdrawing up to 4% of your balance each year to be used as income. (Most financial advisors cite the “4% rule” as a safe bet). But market losses close to retirement combined with these withdrawals can derail even the best-laid plans.
What is sequence-of-return risk, and why should I care?
Mathematically, the sequence of your returns do not matter if you are not taking withdrawals from your portfolio, even with extreme market volatility. For example, a $1,000,000 portfolio that experiences returns of +100% and then -50% will finish with the same balance as a portfolio that has returns of -50% and then +100%. In both cases, the portfolio’s ending balance is the same $1,000,000, even though the average rate of return is 25%.
Now, to illustrate this risk for an individual moving into retirement, let’s use an extreme cash flow example of a retiree who needs to withdraw $500,000 from his/her account at the end of the first year. In the first sequence, the $1,000,000 would grow to $2,000,000 (100% return) and would easily fund the $500,000 withdrawal. Then, in year two, the account balance reduces to $750,000 (-50% return). In contrast, the second sequence would reduce funds from $1,000,000 to $500,000 (-50% return)—and, after the $500,000 withdrawal, the balance would be $0. In this case, the following year’s 100% return is irrelevant.
In reality, a retiree’s withdrawal needs are not that extreme after the first year of retirement. Nonetheless, the fundamental point remains: if losses are experienced during the Retirement Danger Zone, then it can have devastating effects on the longevity of your portfolio.
These losses are much more damaging to your portfolio in the Retirement Danger Zone simply because with each withdrawal you lock in permanent losses when the market is down. When your account does rebound, it does so with less strength and leverage. This is considered a double loss.
How can I protect myself in the Retirement Danger Zone?
With planning and correct asset placement, you can protect against sequence-of-return risks. With a financial advisor’s help, you can learn to play differently, just like linebackers playing in the red zone to prevent a touchdown.
Under a financial advisor’s guidance, the best protection is to diversify your portfolio. Think of it like storing your assets in two buckets—a safe bucket and a growth bucket. When the market is down, you have a non-market correlated asset to supplement income while you let your full in-market account rebound. “Unless you are a market oracle, owning a diverse portfolio is vital to help limit downside risk,” writes Forbes contributor Stephen McBride. “Many investors know that a good asset mix is key to earning steady returns and invest wisely.” Different avenues of “safe bucket” investments may include the following:
- Real estate
- Bond portfolio
- Income annuity
There is no magical combination that will protect against loss, just as there is no single best defensive play for protecting the end zone. But, with the help of a financial coach, you can read the situation and look for the best plays, the best investments, to see your portfolio out of the danger zone and into retirement.
Call or email an Investment Advisor Representative with Allegis Investment Advisors LLC, a SEC Registered Investment Advisor to learn more. 591 Park Ave Suite 101, Idaho Falls ID 83402.