By Gary Marsh
The five years before retirement, while potentially the most financially beneficial period, may also present the greatest risk to your retirement plans. There is a strong argument for being somewhat conservative with your retirement balance over this period if you wish to have a less stressful retirement. Let me step you through the reasons why.
The Risk Behind Impressive Growth
When we look at financial modelling of retirement balances (i.e. the value of your retirement assets) the last five years before retirement are often when your portfolio’s growth is the largest in dollar terms.
By this stage, compounding has done its work, and your balance should be reaching its maximum. In fact, the calculations of accumulated growth in this final stretch can often double your account balance from the previous decade. I cover this in a previous article “You’re Never too Young to Learn This About Retirement”
However, the real world is different and there must always be consideration of the risk of the market taking a significant downturn just before commencing retirement.
A material downturn in investment markets five years either side of retirement will impact you far more than at any other time. Why? Let’s talk about “sequence risk”.
5 Years Before Retirement and Sequence Risk
Sequence risk is a concept that becomes critical as you approach and enter retirement. It’s all about the order of returns and whether you’re adding or subtracting from your balance. When you’re younger in the accumulation phase and adding funds, a market correction doesn’t have the same impact on your savings as your balance is generally smaller, and there is time to recover and grow. But once you’ve built a significant nest egg, the stakes become much much higher. Even a modest negative movement e.g. -5% x $1m = -$50,000 could shorten the longevity of your capital by 2-3 years.
I often talk to clients about “paper profits.” That’s the unrealized (capital) profit in their portfolio. It’s not real in the sense you can’t spend it until you turn it into money. Worse still if you leave paper profits in place there is a chance they can be lost with a market correction. Quite simply, the larger the balance the larger the potential decline in paper terms.
Changing Strategy 5 Years Out
If you’ve done well in investment markets leading up to retirement, fantastic, but it may be time to ‘harvest’ some of those paper gains by converting them into defensive assets like bonds or cash. This may involve shifting part of your portfolio to a more conservative mix, but beware this may have tax consequences so get some advice first.
This strategy helps reduce late-term loss of capital by reducing exposure to market fluctuations. It’s all about reducing the risk of losing some of that hard earned wealth in an attempt to gain a just little more growth.
The trade-off is you may make a little less, but you reduce the risk of losing some of your capital and start retirement on the back foot.
I like a good graph, so I have included one to show the effects of sequence risk both before and after retirement. Please note this is a very simplified example with a number of assumptions, which may not apply to you. As you can see the Pre-Retirement scenario has a material downturn just before retirement. Which shortens capital longevity by around 9 years. This is very similar to the Nightmare scenario where the downturn occurs just after stopping work, but with strong returns leading up to retirement it may cause the investor to maintain their high-risk exposure into retirement. Unsurprisingly the Goldilocks scenario shows a great result with strong returns up to and into retirement, with capital lasting well beyond age 85. While a great result it is rare to see this in the real world.
| Age | ||||||
|---|---|---|---|---|---|---|
| Scenario | 60 | 61 | 62 | 63 | 64 | 65 |
| Pre-Retirement | +7% | +7% | +7% | +7% | -10% | -15% |
| De Risk | +7% | +6.5% | +6% | +5.5% | +5% | +4.8% |
| Goldilocks | +7% | +7% | +7% | +7% | +10% | +12% |
| Nightmare | +7% | +7% | +10% | +12% | -25% | -12% |
A Gradual Shift to Safety
One thing I emphasize to my retiree clients is that de-risking your portfolio doesn’t have to be an all-or-nothing approach. It’s not like flipping a switch. Instead, consider gradually transitioning to higher defensive positions around five years or so before your planned retirement date.
This allows you to capture those remaining growth opportunities while at the same time increasing the level of protection against a major market shock. It’s all about balance. To aid in this de-risking process it is suggested that the forgone growth is replaced with increased savings. That is, if the portfolio would have provided an additional $10,000 of growth, that this be saved by the pre-retiree in defensive assets. By the time they retire, their portfolio is likely to be in a more defensive position, with less exposure to market swings. Thereby reducing sequence risk effects close to and into retirement.
Post-Retirement Risk and Re-Introducing Growth
As you move further into retirement having secured your capital base through the sequence risk period, you’ll need to start thinking about inflation. Inflation erodes purchasing power over time, so leaving your portfolio in a too conservative position forever is not advisable.
Again, it’s not a flick the switch exercise. Consider slowly increasing growth exposure in your portfolio back toward your preferred investment allocation to help offset this inflationary effect. This will be different for everyone and highly dependent on a person’s risk tolerance and day to day living needs. The idea is to keep ahead of inflation while maintaining a solid safety net during the early transition phase.
Balancing Risk and Spending
While I’m talking about post-retirement adjustments, a factor to consider is the balance between your annual drawings (expenses) and portfolio size. If your drawings are high relative to your investment base, you may need to hold slightly more defensive assets. On the flip side, if you’re spending less than your portfolio can sustain, you may have more flexibility to take on growth-oriented investments.
Emotional Decisions and the Danger of Loss
One of the biggest challenges in retirement planning isn’t the math—it’s human nature. It can be hard in a good year of strong growth to move to a more conservative stance before retirement in an attempt to capture as much of those earnings as possible.
But prior to the Global Financial Crisis I saw many late retirees resist shifting to more defensive positions, only to see their portfolios lose up to half or more in months following the correction. If you have 10 or more years until retirement you have a good opportunity to recover by adding more capital and investing sensibly. But if you’re knocking on the door of retirement a loss of such magnitude will either force you to continue working or materially reduce your planned retirement lifestyle.
It’s not easy to walk away from potential gains for sure, but I always remind my clients that protecting what you’ve earned becomes far more important than chasing that last bit of growth.
Practical Steps for the Plus 5 to Minus 5
In summary here are the steps you should consider:
- Understand Sequence Risk. Be aware of the heightened risks during this critical time and adjust your portfolio accordingly.
- Start 5 years before retirement. If you plan to retire at 65, consider adjusting your portfolio around age 60. This may also involve saving a bit more to help lift that final balance.
- Harvest Gains. Move a portion of your paper profits into defensive / safe assets to lock in profits. Beware of tax and transaction costs if you do this. Get some advice first.
- Reassess After Retirement. Don’t let inflation eat away at your purchasing power, review your growth asset exposure once in retirement, keeping in mind your risk profile range.
- Stay Rational by working with a financial advisor. Don’t let emotions drive your decisions. Stick to a plan based on your goals, needs and risk tolerance.
By understanding the significance of the plus five or minus five years, you can navigate this crucial period with confidence, preserving your hard-earned savings and setting yourself up for a secure and fulfilling retirement. If you would like to explore ant of these strategies further, please contact me at People + Partners.
Disclaimer
People & Partners Wealth Management Pty Ltd ABN 67 127 250 613 is a corporate authorised representative of Fortnum Private Wealth Ltd ABN 54 139 889 535, holder of Australian Financial Services Licence (AFSL) No. 357 306. The content of this article is for general informational purposes only and does not constitute personal financial advice. It does not take into account your individual objectives, financial situation, or needs. Any advice we provide will be detailed in a formal advice document. The opinions expressed in this article are those of the authors at the time of writing and should not be taken as a recommendation to act. To the extent permitted by law, Fortnum Private Wealth Ltd and its associates accept no liability for any loss or damage incurred as a result of reliance on this communication.
