Are You in the ‘Retirement Red Zone’?

    Are You in the ‘Retirement Red Zone’?

    By Amy Fontinelle


    > Taking the Next Step

    What would you do if your retirement portfolio took a major hit in the years right before you planned to retire? Would you be able to stay the course, or would you have to postpone retirement? What if the stock market tanked in the early years of your retirement? How would you handle the drop in your portfolio’s value?

    Many people aren’t prepared for these scenarios because they aren’t aware of the threat they pose. You know you’re supposed to save a good chunk of every paycheck for retirement. And you know that the odds favor better performance for your portfolio if you buy and hold your investments and don’t let your emotions convince you to sell when the market underperforms. (Related: Why You Can Win with a Steady Investment Strategy)

    But there’s a good chance you’ve never heard of sequence of returns risk.

    Sequence of returns risk is a fancy way of saying that it matters not only how much your retirement portfolio earns each year on average, but how much it earns in any given year. It’s not a major concern in the decades leading up to retirement because you’re only adding to your portfolio, not withdrawing anything from it. But it becomes a concern when you’re nearing and entering retirement. If the stock market is down in the early years of your retirement and you have to sell stocks at a loss to get enough income for your basic expenses, you can really hurt your portfolio’s value in both the short run and the long run.

    Why Returns Near Retirement Matter So Much

    If you are within five years of retirement, you are in the “retirement red zone,” said Robert R. Johnson, president and CEO of the American College of Financial Services in Bryn Mawr, Pennsylvania, in an interview. He also suggested such investors consider de-risking their portfolios to protect against a large, negative market event. “You simply can't afford to make a big mistake when you have a short time horizon to retirement.”

    Consider two hypothetical retirement portfolios, each with a starting value of $500,000. Portfolio 1 experiences the annual returns of the S&P 500 from 1969 through 1994. Portfolio 2 experiences those same returns but in reverse order. The portfolio holders withdraw $30,000 in year 1 and increases withdrawals by 3 percent each year to account for inflation.  

    The owner of Portfolio 1 experiences the following annual returns during the first five years of retirement: -8.4 percent, 4 percent, 14.3 percent, 19 percent, and -14.8 percent. The owner of Portfolio 2 sees annual returns of 1.3 percent, 10.1 percent, 7.6 percent, 30.4 percent, and -3.1 percent. After five years, Portfolio 1 is worth $385,752, while Portfolio 2 is worth $565,419. Portfolio 1 continues to experience several losing years early on, while Portfolio 2 continues to experience considerable gains.

    Despite the annual drawdowns, Portfolio 2 has actually increased in value 10 years into retirement: it’s worth $1,157,844. Meanwhile, Portfolio 1 is worth just $257,966. The early losses hurt Portfolio 1 so much that after 26 years, it’s nearly exhausted, with a remaining balance of just $19,369. Portfolio 2’s early gains helped it so much that after 26 years, it’s worth $2,555,498.1

    These results offer a compelling example of how the sequence of returns can affect your retirement portfolio.

    Portfolio Diversification Can Help Protect You

    If your portfolio is well diversified with assets that tend to perform differently from each other — international stocks, small company stocks, large company stocks, bonds and real estate — then when one asset class is losing value, you can sell your holdings in another asset class that is increasing in value. If you can wait for the poorly performing assets to recover and avoid selling them at a loss, you likely won’t damage your portfolio or your retirement plans. (Related: Managing Risk)

    Suppose you need to withdraw $50,000 from your portfolio to pay for your housing, food, utilities, health care and other basic expenses. Now, let’s say the value of the shares you were planning to sell recently plummeted from $50 a share to $40 a share: a 20 percent drop. Instead of selling 10,000 shares to get the $50,000 you need, you have to sell 12,500 shares. That’s 2,500 fewer shares in your portfolio that can rebound and help you make up for your losses. Now, imagine that this scenario continues for several years: the effect can be devastating. If it happens early in your retirement years, your portfolio might never recover. But if you have bonds that are performing well, as they often do when stocks are down, you can sell those instead and preserve your portfolio’s value and long-term viability.

    Similarly, while you’re still working but getting close to retirement, if returns are terrible and your portfolio is not well diversified, you might find that your portfolio balance is too small to allow you to retire. This possibility is called retirement date risk.2 You might have to work several years longer as a result while you wait for the stock market to recover.

    If you can’t keep working because of your health or because your company forces you into early retirement, the consequences can again be severe. On the plus side, if you can keep working, you’ll have several extra years of savings to add to your nest egg, and you may be able to use that money to buy stocks that can appreciate in value if the stock market rebounds. (Related: Crazy stock markets? Count your financial eggs...)

    Asset Allocations for Near-Retirees and Recent Retirees

    “Some retirees make the mistake of entirely getting out of the equity markets when approaching retirement, and that is not a prudent strategy,” Johnson said. Given that many retirees live for many years past retirement, having an overly conservative asset allocation means that you risk outliving your assets.

    On the other hand, stocks (and equity-related mutual funds) involve an assortment of risks ranging from individual company performance to industry-specific factors to the fitness of the general economy. Individuals should take into account these risks when considering various strategies for investing, especially near retirement. More conservative approaches may be more appealing.

    “As an individual nears retirement, they should consider reallocating some of their equity holdings to high dividend yielding stocks,” Johnson said. Dividends may help supplement your income, and the prices of dividend-paying stocks generally increase over time. Dividend amounts also generally increase over time. Indeed a variety of large, blue-chip companies (listed in the Dow Jones Industrial Index) have a  long history of increasing their dividend payments to shareholders each year. Such increases may help protect your portfolio’s value against inflation. Of course, history is not a guarantee of future performance.

    Stocks of companies that have good free cash flow are another option to consider if you don’t mind doing the research on individual stocks.3 When a company’s free cash flow – the money available after a company makes payments to sustain its business — is increasing, it’s typically a good sign for the company’s future value and its stock’s future value. It helps a company grow in good times and survive in challenging times. Free cash flow also enables a company to pay dividends, if it chooses, and to increase its dividend payments.

    A new theory to consider is lowering your portfolio’s stock allocation to 30 percent and increasing your bond allocation to 70 percent in the years just before and after retirement — instead of following the conventional wisdom of allocating 100 minus your age to stocks and the rest to bonds. Then, as you age, you increase your 30 percent allocation to stocks and decrease your 70 percent allocation to bonds. Called a “rising equity glide path,” retirement experts Wade Pfau and Michael Kitces state that this strategy can protect against the risk of running out of money, particularly when stock market returns are poor early in retirement.4

    Stocks tend to offer higher returns than bonds in the long run, but they tend to be more volatile: they can gain or lose a lot of value in a short time. In the years just before and after you retire, you want to be sure you have something whose value is relatively stable — bonds — that you can sell for income in case stocks are down to protect against sequence of returns risk.

    Possible Protection with Deferred Income Annuities

    Besides diversification and asset allocation strategies, you can protect against sequence of returns risk and retirement date risk by purchasing a deferred income annuity. Deferred income annuities (DIAs) are sometimes called longevity insurance because they help protect against the risk of running out of money later in retirement. This type of annuity provides guaranteed income, whereas your retirement portfolio may not, depending on how the market performs.

    Johnson said that people who are approaching retirement should start investing in annuities to cover their basic living expenses in retirement. He said they can be excellent vehicles to ensure retirement income. Also, annuitizing part of your portfolio lets you be more aggressive in allocating the rest of your portfolio, he said.

    If you don’t have a guaranteed income from a pension and your monthly Social Security payments aren’t enough to cover all your expenses, a deferred income annuity can offer peace of mind and financial stability. In exchange for a lump sum or a series of up-front payments, you will later receive a steady, predictable annual income.

    An annuity could also protect you against retirement date risk by guaranteeing income starting early in retirement. In this case, you might buy a few years before retirement a deferred income annuity that would start making payments in the year you plan to retire. It will cost more, but you’ll receive income sooner. (Related: Does an Annuity Fit Your Retirement Goals?)

    That’s because the longer you’re willing to wait to start receiving payments, the less a deferred income annuity typically costs because the older you get, the more likely you are to not collect on the annuity or to not collect for too many years. For example, a 58-year-old man who purchased an annuity that provides $12,000 annually would pay $100,000 to start receiving payments at age 68, but he’d pay just $40,000 to start receiving payments at 78, according to a New York Times article.5

    Data from the Social Security Administration say the average man turning 65 today will live to be 84, so he might collect $72,000 on his $40,000 investment. By contrast, if he’d invested that $40,000 at age 58  and earned 8 percent annually on average, he’d have about $186,000 before taxes and inflation at age 78, according to calculations made using Bankrate’s investment calculator.

    Sure, the straight investment returns more, provided that the investment achieves 8 percent each year. But the annuity provides guaranteed income for life, the stock market does not, and $40,000 is relatively little to risk in exchange for that guarantee; or so the argument in favor of these types of “longevity” annuities goes. And if that man lived to be 98, he’d see $240,000 in annuity income.

    Many people are concerned about losing their initial investment if they die before an annuity begins to pay out or after it starts paying out but before getting their money’s worth. Your heirs would receive less than they might have had you not purchased the annuity. But many annuities reduce this risk by offering a death benefit, such as a return of some or the entire principal to your heirs upon death if you haven’t started receiving income payments yet.6 Even if you have started receiving payments but the payments haven’t reached the amount of premium you paid, your heirs may receive a refund of the unused premium.7

    It’s important to protect your retirement portfolio against the possibility of a market downturn in the years immediately before and after your retirement. Proper diversification, asset allocation and possibly a deferred income annuity can help manage these risks.

    More from MassMutual…

    The Impact of the Sequence of Investment Returns

    Protect Yourself against Market Fluctuations in Retirement



    1 “The Impact of the Sequence of Investment Returns: Why a 10 Percent Return Doesn’t Guarantee Success,” MassMutual, 2016.

    2 Nerd’s Eye View blog, “Retirement Date Risk – The Impact of Sequence Of Returns Risk on Those Still Accumulating for Retirement,” February 24, 2016.

    3 Investopedia.com, “Picking Retirement Stocks: Dividends vs. Free Cash Flow,” June 16, 2016.

    4 Wade Pfau and Michael Kitces, “Reducing Retirement Risk With a Rising Equity Glide Path,” Journal of Financial Planning, Vol. 27, No. 1: 38–45.

    5 New York Times, “Buying a Guaranteed Retirement Income, for Some Peace of Mind,” June 6, 2014.

    6 Morningstar, “Deferred Annuities Getting Some Traction,” January 29, 2014.

    7 TIAA, “Dismantling Five Annuity Myths.”

    The information provided is not written or intended as specific tax or legal advice. MassMutual, its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel.

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