Avoiding the Retirement Danger Zone: Taming Sequence of Return Risk

Key Points to Remember

1. Sequence of Return Risk: Early investment losses in retirement can severely impact long-term financial security. Proactive planning is essential to mitigate this risk.
2. The Bucket Approach: Divide your portfolio into three buckets to manage immediate, medium-term, and long-term income needs, ensuring stability and growth.
3. TIPS for Inflation Protection: Utilize Treasury Inflation-Protected Securities (TIPS) to safeguard your retirement income against inflation, maintaining your purchasing power.
4. Strategic Asset Allocation: Align with evidence-based principles, like those of David Swensen, focusing on government bonds for stability and growth assets for long-term returns.
5. Flexible Withdrawal Strategies: Adapt your spending based on market conditions to ensure your retirement savings last throughout your retirement years.

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Retirement, the long-awaited chapter of life, should be a time of relaxation and fulfillment. Yet, for many, the years leading up to and immediately following retirement can be a source of significant anxiety. One often-overlooked threat looms large: sequence of return risk. At Purpose Built, we understand these risks and  plan for them, ensuring your retirement is both secure and enjoyable.

Understanding Sequence of Return Risk: Why Timing Matters

Sequence of return risk refers to the danger of experiencing substantial investment losses early in your retirement years. This risk is particularly acute in the five years before and the five years after you retire, a period we call the "retirement danger zone." Research from Morningstar indicates that nearly 70% of retirement failures (running out of money prematurely) are linked to investment losses within the initial five post-retirement years. This highlights a critical truth: a market downturn immediately after you retire can severely impair your long-term financial stability. Conversely, if your investments perform well during this period, your chances of outliving your savings significantly decrease.

Pre-Retirement Strategy: Fortifying Your Portfolio for Stability

The five years leading up to retirement are crucial for strategic portfolio adjustments. At Purpose Built, we guide our clients through this critical phase, emphasizing risk mitigation and stability, primarily through the "Bucket Approach."

• Gradual De-risking: We recommend a gradual shift away from volatile assets like stocks towards more stable fixed-income investments. This transition cushions your portfolio against potential market shocks. As demonstrated in Morningstar’s "State of Retirement Income" study and our favorite portfolio strategist, David Swensen, diversifying into Treasury bonds increases the safe withdrawal rate, providing a more reliable income stream.
• Bucket 1: Building the Liquidity Reserve: We emphasize establishing "Bucket 1," a highly liquid reserve containing one to two years' worth of living expenses. This bucket, composed of cash or cash equivalents (like money market funds or Fidelity’s cash management accounts), acts as an emergency fund and a buffer against market volatility in the early retirement years. And as of this writing, these are paying a decent yield compared to recent history. 
• Strategic Asset Allocation: Aligning with David Swensen’s principles, we focus on government-issued bonds for the safety and stability buckets above, allowing the growth-focused portion of the portfolio (Bucket 3) to pursue higher returns with reduced risk. It’s essential to maintain a portion of your portfolio in growth assets to ensure long-term purchasing power. Retirement is longer than most people think with inflation becoming the largest threat to success. 

Post-Retirement Strategy: Constructing a Resilient Income Stream

Once you enter retirement, particularly after navigating the critical first five years, we focus on building a robust, inflation-protected income stream using TIPS ladders and maintaining the bucket system.

• Leveraging Bucket 2: As you draw down Bucket 1, we replenish it using income and rebalancing proceeds from Bucket 2. This strategy ensures that your long-term investments in Bucket 3 continue to grow, undisturbed by immediate income needs and insulated from market volatility.
• Bucket 2: We aim to build a "Bucket 2," designed with five to eight years of expenses in high-quality fixed income and stable investments. This bucket serves as the primary source for replenishing Bucket 1, ensuring consistent income flow. Our preferred choice for this is Treasury Inflation-Protected Securities (TIPS), which protect the spending power of your investments.
  
  • Building a TIPS Ladder: A TIPS  ladder provides inflation-adjusted income, maintaining your purchasing power throughout retirement. TIPS are designed to protect against inflation, with their principal value adjusting to the Consumer Price Index (CPI). By staggering the maturity dates of TIPS bonds, we create a predictable and inflation-protected income stream, ensuring a portion of your portfolio matures each year.
• Maintaining Bucket 3: We continue to manage Bucket 3, your long-term growth portfolio, with a focus on diversification and periodic rebalancing. Even after the initial five years, market fluctuations can still impact your retirement security, necessitating vigilant management. After we get through the first five years and the associated sequence of return risk, we actually look to increase growth investments in the portfolio as longevity risk and inflation become a more concerning threat. 
• Flexible Withdrawal Strategies: We advocate for flexible withdrawal strategies, such as guardrail strategies, allowing you to adjust your spending based on market conditions. This approach helps preserve your portfolio during market downturns, ensuring long-term sustainability.

Comparative Analysis: Other Retirement Income Strategies

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Securing Your Future with Purpose Built Financial Services

Securing a comfortable and financially stable retirement requires a comprehensive and proactive approach. At Purpose Buil, we specialize in crafting customized retirement strategies that prioritize safety, stability, and inflation protection. By integrating the bucket approach with TIPS ladders and adhering to evidence-based principles, we empower our clients to navigate the retirement danger zone with confidence.

Now is the time to take control of your financial future. Whether you need assistance with tax forecasting, optimizing your benefits, or creating a comprehensive financial plan, Purpose Built is here to help. Schedule a free, no-obligation meeting today to discover how we can help you achieve your retirement goals and make 2025 your most financially secure year yet. Let us guide you towards smarter decisions and greater savings.

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Frequently Asked Questions (FAQs)

Q: What is sequence of return risk and why is it important in retirement planning?

A: Sequence of return risk refers to the danger of experiencing significant investment losses early in retirement. This is crucial because early losses can severely deplete your retirement savings, making it difficult to maintain your desired lifestyle throughout your retirement years. Understanding and mitigating this risk is a core component of effective retirement planning.

Q: How does the "Bucket Approach" help manage retirement income?

A: The "Bucket Approach" divides your retirement portfolio into three segments: Bucket 1 (liquid assets for immediate needs), Bucket 2 (stable income for medium-term needs), and Bucket 3 (growth assets for long-term goals). This strategy helps manage cash flow, mitigate risk, and ensure a steady income stream while protecting against market volatility.

Q: What are TIPS (Treasury Inflation-Protected Securities) and why are they recommended for retirement income?

A: TIPS are government bonds that adjust their principal value with inflation, as measured by the Consumer Price Index (CPI). They are recommended for retirement income because they provide inflation protection, ensuring your purchasing power remains stable throughout retirement.

Q: Are TIPS taxable, and how can I minimize the tax impact?

A: Yes, TIPS are taxable. The inflation adjustments to the principal are taxed annually (known as "phantom income"). To minimize tax impact, it’s advisable to hold TIPS in tax-advantaged accounts like IRAs or 401(k)s.

Q: What are flexible withdrawal strategies, and why are they important in retirement?

A: Flexible withdrawal strategies, such as guardrail strategies, allow you to adjust your spending based on market conditions. This helps preserve your portfolio during market downturns and ensures long-term sustainability, preventing premature depletion of your retirement funds.

Final Thoughts

For retirees seeking a secure and predictable income stream, a well-structured retirement plan is essential. At Purpose Built, we are committed to providing personalized guidance and tailored strategies to ensure your retirement is both financially secure and fulfilling. By integrating the bucket approach with TIPS ladders and adhering to evidence-based principles, we help our clients navigate the retirement danger zone with confidence.

Schedule a meeting today, and let's make 2025 your best financial year yet.

About the Author

Sean Lovison, CPA, CFP®, is a flat fee-only financial planner based in Moorestown, New Jersey, serving clients virtually nationwide. After spending 14 years as a corporate chief financial officer (CFO), receiving and designing compensation plans, he decided to help others navigate their plans.

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