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How to Navigate the Retirement Danger Zone
- By Travis Echols
- •
- 29 Jul, 2017
Originally written on 2/28/2017.
When you are white-water rafting, there are certain places on the river that can be dangerous to your health. You need to carefully navigate the rapids to avoid injury.
So it is in retirement planning. There are places where making the wrong move can be dangerous to your financial health. The white-water rapids in retirement are the ten years preceding retirement and the ten years at the beginning of retirement.
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Executive Summary
The danger zone in retirement is the 10 years before, and the 10 years after, retirement begins. This perilous 20-year period should be prepared for long in advance and carefully navigated when that time comes. Due to portfolio size effect and 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.
The research suggests that it generally makes sense for a person to invest heavily in stocks when young and begin to significantly decrease stock exposure as retirement age approaches. And once in retirement, it is best to use a flat-percentage stock allocation throughout retirement. A further enhancement, using this approach, is to vary stock exposure by 10 to 20% based on market valuations (CAPE and/or PB), before and during retirement.
Now let's look at the problem in more detail and a two-part solution
The reason this danger zone, sometimes called the red zone, exists is two-fold: portfolio size effect and sequence-of-returns risk.
- Portfolio size effect is the greater effect your portfolio size has on your retirement security as compared to your future savings when your portfolio becomes larger and your future savings potential becomes smaller due to fewer years to work. The returns earned on a large portfolio dwarfs your future contributions. For example, let's say you have a a 10% annual gain on $1 million. That gain is $100,000! This gain has a much greater effect on your wealth than your $18,000 savings that year. This portfolio size effect can work against you as well, since your $18,000/year contributions can be dwarfed by losses of $100,000 or more.
- Sequence-of-returns risk occurs if you are taking distributions from your portfolio. If you never take money from your portfolio, the order or sequence of returns that you earn doesn’t matter. You’ll have the same at the end, regardless of the sequence. But if you are taking distributions, negative investment returns in the first decade of withdrawals can have a much more harmful effect as far as your money lasting your lifetime than negative returns at the end of the withdrawal period. Some have called this problem reverse dollar cost averaging. Since you are withdrawing a fixed dollar amount each month, you are systematically selling more shares when prices are low and fewer shares when prices are high. This can be devastating if it lasts for several years in the early years of retirement. Why it does not matter as much for the negative returns to come later in retirement is that you have already racked up higher returns earlier. It is having to sell your seed corn that limits your harvest for years to come; whereas losing a big harvest after your seed corn has multiplied is not nearly as detrimental to your money lasting your entire lifetime.
Carefully manage your portfolio risk in the danger zone
The investor's tension during this danger zone is apparent. The more you have in stocks, generally the better able you will be to outpace inflation and thus enjoy a better lifestyle. See Why Simple Savers Lose in the End. But at the point you retire, you are the most vulnerable to sequence-of-returns risk. So you want stock exposure for growth to cover a long retirement, but you have to protect yourself in case you retire at the start of a long bear market in stocks.
Note: When I say stocks, I am referring to a diversified collection of stocks that minimizes company risk. This can be accomplished by owning many individual stocks, mutual funds or Exchange Traded Funds (ETFs). However, market risk is still present.
If the danger zone in retirement is the ten years preceding retirement and the ten years at the beginning of retirement, some studies have recommended a V-shaped equity (i.e., stock) allocation over time. Ten years before retirement, you would begin to lower your equity exposure. Then during retirement, you draw from cash and bonds, allowing your equity percentage to rise. Since the potential negative impact of a market crash subsides after the first ten years, a greater stock percentage later in retirement would make up for any previous bear market--and a market downturn later would not be devastating since you have already lived past the danger zone.This may work mathematically, but I find clients not usually amenable to taking on more and more volatility in their golden years. However, it does suggest that a continually decreasing stock percentage with age is not the best approach in retirement. And thus a flat stock allocation is usually the best solution.
This flat allocation in retirement is also recommended by Russell Research and Josh Cohen, CFA. Mr. Cohen writes in his AAII July 2010 article, Allocation in Retirement: A Flat Glide Path Always Make Sense, "Retirees face their maximum risk exposure the day they retire...and they are quite vulnerable to sequential risk. If the market does well in the early years of retirement, when retirees are starting to make withdrawals, then their accounts should maintain reasonable balances. As their time horizons shorten, the likelihood that their accounts will run out of money decreases and therefore there is no need to decrease risk. Conversely, if the market does poorly in the early years of retirement, retirees will experience a rapidly declining account balance. Decreasing stock allocations later locks in their losses--and smaller allocations can't do enough to help retirees recover their savings."
All of this would suggest that it generally makes sense for a person to invest heavily in stocks when young and begin to decrease stock exposure as retirement age approaches. This is called the glide path to retirement. And once in retirement, it is best to rebalance to a flat percentage stock allocation throughout retirement. This is called the glide path in retirement.
Dynamically adjust your stock exposure based on market valuation
This decreasing glide path to a flat average asset allocation in retirement makes alot of sense. But historical data shows that the percentage of stocks a retiree needs differs based on when retirement starts relative to market prices. If we can find a correlation and use that to forecast market returns going forward, we can enhance the average glide path.
Fundamental analysis of individual stocks has long been recognized and popularized by men like Benjamin Graham and Warren Buffet. The question is can some aggregate valuation be applied to stock markets.
In 1934, Graham & Dodd recommended using an
average of earnings for the last 7 to 10 years to calculate the Price to Earnings (PE) of stocks. Following this advice, in 1998, Campbell and Shiller developed a cyclically
adjusted price-to-earnings ratio (CAPE).
This valuation measurement calculates the current market price in relation to the average inflation-adjusted profits of the previous 10 years. This CAPE (or Shiller PE10) can be used to assess
whether the value of a market is high or low compared to its profit level adjusted for an economic cycle.
The May 2008 issue of The Kitces Report shows the strong inverse relationship between the Shiller PE10 and subsequent stock 15-year return for a 60% stocks/40% bonds portfolio.
Graph 1. PE10 versus subsequent 15-year return of balanced portfolio
Star Capital's 2016 report, Predicting Stock Market Returns Using the Shiller CAPE,
acknowledges some criticisms but confirms
the CAPE's predictive value. Along with price-to-book (PB) ratios, they
use the Shiller CAPE to predict long term returns of various stock asset
classes, foreign and domestic.
Graph 2. CAPE in the S&P 500 since 1881
(January 2018 addendum to this article: For a defense of the CAPE in projecting long-term returns, reference Research Affiliates' article entitled CAPE Fear: Why the Naysayers are Wrong, written by Rob Arnott, Vitali Kalesnik, and Jim Masturzo.)
It turns out that if you employ a dynamic allocation based on valuations that can forecast stocks’ general performance over the next long period, you can underweight your stock allocation to mitigate sequence-of-returns risk. And if you overweight stocks when markets are favorably priced, studies show this has even a greater impact on increasing your safe withdrawal rate. See my safe withdrawal rate article, Three Steps to Safely Maximize Your Portfolio Income.
Table 1
below is an example of a full dynamic rebalancing asset allocation
guide, representing the percentage of the portfolio to be in
stocks.
Table 1. Full dynamic rebalancing asset allocation guide
Note: Age range of 50-60 years can be altered if retirement is earler or later than 60. In the case of later retirement, it still may be safer to use age 60 as the end of the decreasing glide path, since early retirement in one’s 60s is not uncommon due to unexpected events such as layoffs, sickness, or family issues.
*gp = glide path of decreasing stocks over age range
Table 1 is graphically depicted below.
Graph 3. Stock Allocation Under Various Market Conditions
This strategy is not an attempt at market timing, as it cannot predict tops and bottoms. Rather, it is a way of assessing the risk/return potential of stocks over the subsequent decade or more, and rebalancing the portfolio accordingly by 10 to 20%. This is a guideline. Of course, your personal goals and risk tolerance should also guide your decision.
In summary, during retirement (or age 60, whichever is earlier), you want to use a flat percentage that is fully dynamically adjusted to decrease sequence-of-returns risk and increase the safe withdrawal rate. This flat asset allocation approach during retirement, with full dynamic rebalancing gives you the opportunity to make up for below-average performance and lock in above-average performance, thereby optimizing portfolio returns and withdrawal income.
We all need help in areas outside of our field of expertise. I would love to help you with your retirement planning. For a complimentary review of your retirement plan, contact me.
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- Liquidity--Retirement assets are not being locked up or annuitized such that capital is not available for emergencies.
- Income—Using an optimized withdrawal rate, an increasing income is produced to combat inflation (unlike many pensions, bank and insurance strategies that are not inflation-adjusted).
- Growth--assets that can combat inflation over a 20 to 30-year period, giving the retiree more income and upside potential under normal and good economic times.
- Safety--manages the myriad of investment risks like market risk, inflation risk, and credit risk. Under worst-case scenarios, if withdrawal amounts are adjusted by using guardrails, the portfolio can still provide a lifetime income.
Here is an executive summary of how to build up a portfolio for retirement in seven steps.
1. Values clarification and goal-setting . Figure out the income objective and capability of your retirement assets in lifestyle terms, then financial terms. In other words, set realistic, specific, financial goals based on your core life values.
2. Asset allocation glide path . Figure out how to diversify your retirement assets among stocks, bonds, and cash, based on your age, risk tolerance, retirement goals, and changing market values.
3. Valuation-dependent efficient frontier . Figure out which areas of the markets are historically inexpensive, and which are historically expensive. Don’t take on more volatility than you need to for the growth you need or desire.
4. Multi-asset class approach . Diversify one more step for more growth and less volatility. Put more money in the specific market areas that are less expensive and less money in the specific market areas that are more expensive.
5. Tax-aware asset location and distribution . Save as much on taxes as possible by figuring out which type of investments should be held in which types of accounts. If you are drawing an income from your assets, figure out the least-costly order for making withdrawals.
6. Investment selection based on account type (qualified, nonqualified) and asset-class propensity and magnitude of outperformance (passive, factor, managed, etc. ). Figure out what kind of investment to use (index mutual fund, factor mutual fund, actively managed mutual fund, single factor ETF, multifactor ETF, passive ETF, individual stocks, individual bonds, Unit Investment Trust, closed-end fund, etc.) based on the account type, asset class, and growth and income needs.
7. Rules-guided rebalancing based on retirement glide path and multi-asset-class approach . Readjust the investment mix based on your changing personal situation and changing market values.
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.
Here is a summary of the details backing this approach. Also, click here for more background information regarding my investment philosophy.
1. Values clarification and goal-setting
Investment planning for (or in) retirement starts with retirement planning. You start with thinking about your life goals...your dreams...your ideal life in retirement. It could involve doing no work, working part-time, or doing seasonal work. Your ideal life could be going back to school, spending more time with family, traveling, ministry, etc.
Ask yourself questions like, "What would I want to do if I
didn't need to work for money?" or "What are the most important
dangers, opportunities, and strengths I need to address?" or“Ten years from now, if I am looking back on a successful
ten years, what will I have achieved?”
This conversation allows you to create specific
goals around your most cherished values. And your goals will be unique to you.
You then design an investment plan to help you live your ideal life.
This kind of goal-focused, plan-driven approach minimizes the
chances of making bad investment choices based on current events and emotions.
Instead, you can choose and maintain the
specific mix of investments that can best deliver the results you need--using a
disciplined, research-driven approach.
2. Asset allocation glide path
The next major question is what kind of investments do you need to meet your goals. All investments have risk. Even "safe" investments over long periods have inflation risk. No single investment delivers growth, high income, and safety of principal. The key is designing a portfolio that balances them in a way that supports your retirement objectives.
And this mix may change over time. For example, for most people, it makes sense to gradually decrease their exposure to high-growth, high-volatility assets like stocks (i.e., equities) as they approach retirement. In retirement, it is usually best to maintain a flat equity glide path, dynamically adjusted for valuation. This approach protects you from the retirement-danger-zone risks of portfolio size effect and sequence risk, while allowing you to take advantage of bear markets and market corrections. See How to Navigate the Retirement Danger Zone .
- Liquidity--Retirement assets are not being locked up or annuitized such that capital is not available for emergencies.
- Income—Using an optimized withdrawal rate, an increasing income is produced to combat inflation (unlike many pensions, bank and insurance strategies that are not inflation-adjusted).
- Growth--assets that can combat inflation over a 20 to 30-year period, giving the retiree more income and upside potential under normal and good economic times.
- Safety--manages the myriad of investment risks like market risk, inflation risk, and credit risk. Under worst-case scenarios, if withdrawal amounts are adjusted by using guardrails, the portfolio can still provide a lifetime income.
Here is an executive summary of how to build up a portfolio for retirement in seven steps.
1. Values clarification and goal-setting . Figure out the income objective and capability of your retirement assets in lifestyle terms, then financial terms. In other words, set realistic, specific, financial goals based on your core life values.
2. Asset allocation glide path . Figure out how to diversify your retirement assets among stocks, bonds, and cash, based on your age, risk tolerance, retirement goals, and changing market values.
3. Valuation-dependent efficient frontier . Figure out which areas of the markets are historically inexpensive, and which are historically expensive. Don’t take on more volatility than you need to for the growth you need or desire.
4. Multi-asset class approach . Diversify one more step for more growth and less volatility. Put more money in the specific market areas that are less expensive and less money in the specific market areas that are more expensive.
5. Tax-aware asset location and distribution . Save as much on taxes as possible by figuring out which type of investments should be held in which types of accounts. If you are drawing an income from your assets, figure out the least-costly order for making withdrawals.
6. Investment selection based on account type (qualified, nonqualified) and asset-class propensity and magnitude of outperformance (passive, factor, managed, etc. ). Figure out what kind of investment to use (index mutual fund, factor mutual fund, actively managed mutual fund, single factor ETF, multifactor ETF, passive ETF, individual stocks, individual bonds, Unit Investment Trust, closed-end fund, etc.) based on the account type, asset class, and growth and income needs.
7. Rules-guided rebalancing based on retirement glide path and multi-asset-class approach . Readjust the investment mix based on your changing personal situation and changing market values.
Sign up to receive my free monthly email articles...because you want to make the most out of your retirement
.
Here is a summary of the details backing this approach. Also, click here for more background information regarding my investment philosophy.
1. Values clarification and goal-setting
Investment planning for (or in) retirement starts with retirement planning. You start with thinking about your life goals...your dreams...your ideal life in retirement. It could involve doing no work, working part-time, or doing seasonal work. Your ideal life could be going back to school, spending more time with family, traveling, ministry, etc.
Ask yourself questions like, "What would I want to do if I
didn't need to work for money?" or "What are the most important
dangers, opportunities, and strengths I need to address?" or“Ten years from now, if I am looking back on a successful
ten years, what will I have achieved?”
This conversation allows you to create specific
goals around your most cherished values. And your goals will be unique to you.
You then design an investment plan to help you live your ideal life.
This kind of goal-focused, plan-driven approach minimizes the
chances of making bad investment choices based on current events and emotions.
Instead, you can choose and maintain the
specific mix of investments that can best deliver the results you need--using a
disciplined, research-driven approach.
2. Asset allocation glide path
The next major question is what kind of investments do you need to meet your goals. All investments have risk. Even "safe" investments over long periods have inflation risk. No single investment delivers growth, high income, and safety of principal. The key is designing a portfolio that balances them in a way that supports your retirement objectives.
And this mix may change over time. For example, for most people, it makes sense to gradually decrease their exposure to high-growth, high-volatility assets like stocks (i.e., equities) as they approach retirement. In retirement, it is usually best to maintain a flat equity glide path, dynamically adjusted for valuation. This approach protects you from the retirement-danger-zone risks of portfolio size effect and sequence risk, while allowing you to take advantage of bear markets and market corrections. See How to Navigate the Retirement Danger Zone .
Protecting your lifetime retirement savings from excessive taxes is a crucial part of holistic financial planning. This involves protecting your IRA, 401k, lump sum pension rollover, Social Security, and any other type of retirement account or income stream from crushing tax rates.
So let's be sure to differentiate tax preparation
from tax planning
.
Tax preparation , also called tax return preparation, looks backward, one year at a time, to get the numbers right to accurately calculate your tax liability (and how much you owe or overpaid).
Tax planning on the other hand looks at taxes in the context of your overall financial picture. A tax planner not only looks in the rear-view mirror but will look forward 20 to 30 years at your projected tax liability and ask what can be done to lower your lifetime tax bill.
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If you have savings outside of pretax retirement accounts invested in capital assets (like stocks, bonds, ETFs, mutual funds, precious metals, jewelry, and real estate) which have large unrealized capital gains, this article is for you. You may be missing the opportunity to pay zero taxes NOW instead of 15% or higher rates in the future. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
.
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Originally written on Aug 2, 2018 and updated for tax law changes.
If you are no longer working and have reached the age of 72,
you probably know about Uncle Sam’s rule for you to take a Required Minimum Distribution
(RMD) from your traditional and rollover IRA(s) each year for the rest of your life. You can always withdraw more,
but this requirement is the minimum
you must take or be severely penalized. Fortunately,
this rule does not apply to Roth IRAs. (The SECURE Act of 2019 changed the starting RMD age from 70½ to 72 starting in 2020, but fortunately you can still make a Qualified Charitable Distribution (QCD) starting the year you turn 70½.)
Sign up to receive other helpful email articles on retirement planning--free of charge
.
If you have delayed paying taxes in your pretax IRA, 401(k), or 403(b), etc, there comes a time when the IRS wants their taxes. And if you don’t give them their taxes based on their required withdrawal schedule, you'll get hit with a 50% penalty on top of what you owed.
Along with Social Security and other retirement income, this RMD can significantly raise your tax rate. Also read How to Dodge the Social Security Tax Torpedo . There are not many ways to reduce this tax burden. In the past, retirees have used various deductions including charitable cash contributions and gifting of highly appreciated assets to charities. (The latter not only gives you, the donor, a deduction but also avoids a long-term capital gains tax bill.)
However, with the passing of the Tax Cuts and Jobs Act of 2017 (TCJA) , with its almost doubling of the standard deduction, itemizing deductions won’t make sense for near as many retirees. Ah, but there is still a strategy. But first let’s better understand the RMD.
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The latest book I am reading is “ The Psychology of Money ” by Morgan Housel. Chapter 3 is entitled “Never Enough”. In this chapter, Housel talks about when rich people do crazy things. He tells stories of wealthy people who never had a sense of enough and wrecked their reputations, families, freedom, and happiness because of it. I have also talked to older couples who tell me they once had a much better retirement in view, but the quest for more led them to make unwise investment decisions that left them financially crippled in retirement. The importance of knowing when you have enough is not only vital to when you retire but also how you retire. It can affect how you invest, how you withdraw, and your overall satisfaction before and during retirement. Be sure to read to the end where I summarize a few key takeaways. Housel makes the four following observations in chapter 3 of his book. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
.
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Whether you do mini-Roth conversions over several years or big Roth conversions in a few strategic years, the Roth conversion strategy could save you tens if not hundreds of thousands of dollars over your retirement. This article will get deep into the issues of Roth conversions for retirees and the ten steps to take to be sure it is done properly. Be sure to scan or read to the end where I will give you the simple answer to getting your Roth conversion questions answered. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
.
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Making big financial decisions immediately following the death of a close family member can be dangerous. It is often best to allow some time before tackling big financial decisions. On the other hand, some people find getting immersed in the finances is helpful in coping with the loss. Whatever way is best for you, you will need to give it your
careful attention to avoid big financial mistakes. The different types of accounts have different rules. I'll address the most common types. In the case of the death of a parent or anyone other than your spouse in which you are a non-spouse beneficiary, there are many rules that you must know to make the best decision for you and your family. (In this article, I use the common parent-child inheritance, but the planning strategies can apply to other non-spouse situations.) Your decisions can have major tax and investment consequences, both now and in the future. And some of these decisions have time deadlines keyed to your parent’s date of death. Also, some of these decisions are irreversible. You can download my free Estate Planning Survivor Checklist here
.
So, you don’t want to rush in and make decisions without knowing the rules, and you don’t want to wait too long and be stuck with fewer options. (In this article, I am not addressing estate taxes. As of 2021, only estates valued at $11.70 million or more are subject to federal estate tax. But there are plenty of other tax pitfalls to navigate around. I am also going to focus on liquid savings like investment and retirement accounts, versus real estate which will be for another time.) Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Delaying Social Security makes a lot of sense for many retirees; but there are common pitfalls that can cost you a bundle. As you know, the longer you delay your Social Security Retirement benefit, the higher your lifetime monthly payments are figured to be. This increase in delaying continues until age 70, after which there are no further increases for delaying. This increase for each month that you delay filing is not small, especially considering the current low interest rates. Even after full Social Security age, your payment goes up by 8% per year until age 70. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . Here are the five big mistakes of delaying your Social Security retirement benefit. |
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Investment Advisory Services offered through JT Stratford, LLC. JT Stratford, LLC and Echols Financial Services, LLC are separate entities.
Serving Cumming, GA, Forsyth County, and the surrounding areas of John's Creek, Alpharetta, Milton, Duluth, Buford, Suwanee, Flowery Branch, and Gainesville
