Retirement Success Threat #3 of 5 - Why You Should Be Wary of the Danger Zone

By Jeffrey Meenes, CFP® (Published Date May 11, 2023)

When it comes to prudent investment advice, we financial professionals are always harping on the importance of keeping a long-term view. 

“Hold a globally diversified portfolio that captures upside potentially and hedges against over concentrated risk.”

“Don’t prematurely jump in and out of the market.”

“Buy and hold for long-term gains.”

But, there are a few times in your financial life when the short-term view must be more closely monitored. One of these is what I refer to as the Danger Zone, or the few years right before and right after you retire. These are windows of opportunity that can drastically impact if and when you retire and how much you can safely drawdown each year once you do.

The Danger Zone and Sequence Risk

Simply put, the sequence of investment returns and the inflation rate during the Danger Zone years will have an enormous impact on your financial security. In this time period, there is a real risk of experiencing low or negative market returns right before, or right as, your planned withdrawals begin. This is what is known as 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 you anticipated.

Essentially, sequencing will impact your safe withdrawal rate. And unfortunately, this number will vary—sometimes significantly. Because sequence of returns is determined by the date portfolio withdrawals begin, they cannot be known and factored in ahead of time. That is why it is so important to get your years in the Danger Zone right. The decisions you make (or fail to make) in this time will determine the outcome of your future.

Right now, unfortunately, we as a nation are experiencing historic levels of uncertainty. Talks of a looming recession have called many individuals' retirement plans into question. Is it safe to retire now? Will my portfolio be able to 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 significantly decrease stock exposure as retirement age approaches. 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 capital you lose, it takes more than that to recover it and get back to the breakeven point.

For example, if you experience a 10% loss, you’ll need at least an 11.11% to return to get back to where you started.

A 15% loss takes a 17.65% to recover.

As the loss grows, the size of the return needed to recover increases at a faster pace.

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 near 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

As a working professional approaching 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 opportunity for growth over a potentially long retirement period.

So, the way your portfolio is allocated and your financial plan for funding retirement must be carefully structured to get things right to avoid experiencing any significant loss should we enter into a bear market—or worse—a recession. Lean on the expertise of your financial advisor to keep your portfolio in a position to capture potential returns, but also 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 much threat to your portfolio’s longevity.

A negative sequence of returns is no doubt a frightening possibility all pre-retirees are facing 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 are revisiting your plan more frequently. You may need to adjust your strategy as the date approaches.