Navigating the Retirement Danger Zone: A Closer Look at Risks and Strategies
By Jeffrey Meenes, CFP® (Published Date September 10, 2024)
When it comes to prudent investment advice, financial professionals consistently emphasize the importance of maintaining a long-term perspective: "hold a globally diversified portfolio that captures potential upside while hedging against over-concentrated risk"; "don't prematurely jump in and out of the market"; and "buy and hold for long-term gains".
However, there are critical periods in your financial life when a short-term view becomes essential. One such period is the "Danger Zone," the few years immediately before and after retirement, which can significantly affect the timing of your retirement and the amount you can safely withdraw each year.
The Danger Zone and Sequence Risk
Simply put, the sequence of investment returns and the inflation rate during the Danger Zone years will enormously impact your financial security. During this period, there is a real risk of experiencing low or negative market returns right before or right as your planned withdrawals begin. This is known as the sequence of returns risk.
But, the sequence of returns also has remarkable upside potential when the market posts unusually high investment returns in this transitional period. Where negative returns in the Danger Zone can forestall your retirement or force you to live on a smaller income, positive returns can help you build even greater wealth than anticipated.
Essentially, sequencing will impact your safe withdrawal rate. Unfortunately, this number will vary—sometimes significantly. Because the sequence of returns is determined by the date portfolio withdrawals begin, they cannot be known and factored in ahead of time. That is why getting your years in the Danger Zone right is so important. The decisions you make (or fail to make) at this time will determine the outcome of your future.
Unfortunately, we as a nation are experiencing historic levels of uncertainty. Talks of a looming recession have questioned many individuals' retirement plans. Is it safe to retire now? Will my portfolio handle a few bad years in the Danger Zone? If not, what should I do (or not do) right now?
Recovering from Loss is Harder
Research suggests that it generally makes sense for a person to invest heavily in stocks in the younger years and begin to decrease stock exposure as retirement age approaches significantly. Here’s why:
Recovering from loss is hard. And the recovery process is not V-shaped. That is, the rate of return to recover from loss is exponentially higher than the actual rate of that loss.
For every percentage point in investment value, you lose, it takes more than that to recover and return to the breakeven point.
For example, if you experience a 10% loss, you’ll need at least 11.11% to return to your starting point.
A 15% loss takes a 17.65% return to recover.
As the loss grows, the return size needed to recover increases faster.
A 50% loss requires a 100% gain to recover, and an 80% percent loss requires a 400% gain just to get your portfolio back to where it started.
The closer you are to retirement, the more devastating the impact of loss will be because of the time it takes to regain lost capital.
How to Prepare for the Danger Zone
It is critical to adequately mitigate risk and hedge against market fluctuation in order to avoid postponing retirement or having to return to work. Due to sequence-of-returns risk, investors need to carefully manage stock market risk in the Danger Zone while still giving themselves the opportunity for growth over a potentially long retirement period.
So, your portfolio allocation and financial plan for funding retirement must be carefully structured to avoid experiencing any significant loss should we enter a bear market—or worse—a recession. Lean on the expertise of a qualified financial advisor to keep your portfolio in a position to capture potential returns and protect against volatility.
It may also be a good idea to keep a healthy cash reserve during the years that make up the Danger Zone to cover necessary expenses should withdrawing from your portfolio right away pose too great a threat to its longevity.
A negative sequence of returns is undoubtedly a frightening possibility all pre-retirees face right now, especially in this economic environment. If you are nearing retirement or are even within a decade of your planned retirement date, make sure you revisit your plan more frequently. You may need to adjust your strategy as the date approaches.
Are you interested in learning more about how we help you protect against these and other retirement risks? We encourage you to visit our website and learn about our comprehensive wealth management services. If Meenes Wealth Partners sounds like a good fit, schedule a complimentary Get Acquainted meeting to discuss the possibility of working together.