3 Retirement Planning Risks to Avoid

Have you considered what might happen to your retirement plans if a recession or bear market occurs in the years leading up to your retirement or in the first few years of your retirement? Have you considered the risk involved with making changes to your portfolio in response to bad economic news or market events?

Today I’m going to walk you through the three of the most important risk factors that you need to consider when you reach the retirement red-zone so that you can make sure you are prepared for any possible situation that might come up in this time.

RETIREMENT RED-ZONE RISKS

In our last retirement video we covered the basics of retirement planning and we answered the three most important questions:

How much money do you need to retire?
How long will it take for you to save that money?
How do you make sure you never run out of money while you are in retirement?

If you haven’t watched that video yet, please go watch that video first and then come back and watch this video.

In this video we are going to cover the three biggest risks to be aware of as you reach the retirement red-zone. The retirement red zone is the five year period before you retire and the five year period after you retire. If you make the wrong decisions in the red-zone you can actually completely, materially derail your ability to actually retire at all.

The 3 risks are:

Longevity risk
Behavior risk
Sequence risk

Longevity Risk

First up we have Longevity risk, longevity risk is this really terrifying concept where you end up outliving your money while retired and then you are left to fend for yourself. In our previous retirement video (Can you Afford to Retire) we explained the idea of the 4% rule and how, if used correctly, you can have confidence that you will never run out of money in retirement.

Let me just add that the 4% rule is not a 100% guarantee of success, its really important that you have the right amount of insurance coverage because that 4% calculation can be completely compromised if you experience a catastrophic medical emergency or life changing event that forces you to take from you nest-egg to cover it, especially if that withdrawal happens in the red-zone period.

Behavior Risk

In 1997 the quarterly journal of economics published a study by Richard Thaler called “The Effect of Myopia and Loss Aversion on Risk Taking”. In the study, the participants where given a basic 50/50 stock and bond portfolio to manage. In all cases the returns were identical across all the portfolios and the participants.

One group of participants were given monthly statements of the performance of their portfolio where as the other group were given just the annual performance statements. Each time the participants received a portfolio statement they were required to make a decision about how to react. They didn’t have to react at all, but they needed to report back to the researchers what action they wished to take, if any.

The results of the study showed that the investors who saw the performance statments monthly were more likely to react by reducing their stock allocation.

The second group of investors, who only saw their performance statements annually actually had the opposite reaction. Rather than reducing their stock allocations these investors were more likely to keep their stock investment as-is or even increase their stock holdings.

Why did these investors behave the way they did? Well the group of investors who were getting monthly statements were seeing stock losses 39% of the time whereas the investors who recieved annual statements only saw losses 14% of the time. The study implies that the more we follow our returns the more likely we are to tweak our investments and that usually leads to much lower overall returns.

This is why its so important to have an investment plan; a strategy that uses a balanced, risk-adjusted portfolio that will produce the required level of growth and limit the potential down-side.

If you’re wondering which portfolios I recommend, watch my portfolios analysis playlist where I cover some of my favorite safe portfolios which include the All-Weather, Permanent Portfolio, The Golden Butterfly, The Larry Portfolio, and others.

Sequence Risk

The last, and arguable most important, risk you need to prepare for is sequence of returns risk. Take a look at this table.

This is a portfolio growth projection for an investor who we’ll call Kim. Kim has determines that she needs about $35K worth of income from her portfolio each year which will supplement a modest government pension and some other small income she earns from a few internet side hustles.

Based on her needs she’s expecting that its gonna take her about 10-11 years for her nest egg to grow to the $875K or so she needs to cover the $35K worth of annual income. This projection is based on earning an 8% return from her retirement savings each year as well as the home equity she is earning, and her 40% savings rate.

To put this sequence risk idea into perspective, take a look at this chart of the S&P 500 Stock Index.

Note how in March of 2000 the index hits resistance at $160 per share. Follow the dotted line to May 1st of 2013 when it finally recovers.

Things aren’t any better when it comes to the NASDAQ-100 Index, ticker symbol QQQ.

You can see that it took 17 years for the NASDAQ to recover from the dotcom crash of 2000.

I want you to imagine your entire investment portfolio was being 100% invested in this index (also known as The Simple Path to Wealth strategy). You have been diligently making contribution each and every payday throughout the 1980s and 1990s and you are expecting to retire at any point during the first 10 years of the new millennium. What do you think is going to happen to your retirement plans?

Not only are you not retiring in the 2000s you may not be retiring at all in the case of the NASDAQ. You may very well have died before you saw the NASDAQ100 index recover from its crash. Some people build an entire nest egg from start to finish in less than the 17 years it took for the NASDAQ to recover!

So what’s the solution here? Well you want to think about your retirement plan as a ladder which you ascend and descend over time. The bottom of the ladder is 100% stocks, or high growth assets and the top of the ladder is a mixture of government treasuries, gold, commodities, and some stocks.

As you ascend this ladder the risk increases the higher you go. For each few rungs you ascend you shift your allocation from stocks into other asset classes that are loosely or negatively correlated with stocks. Eventually you will reach the top of the ladder which is the day you retire. This is where your risk is the highest and your stocks allocation should be the lowest.

Then you repeat the procedure in reverse as you descend the ladder. If the first 5 years or so of retirement have resulted in a lot of growth then you might shift into a conservative wealth preservation portfolio rather than adding back in more stocks but that’s a decision only you can make.

CONCLUSION

I promised to explain the three most important risks that we must consider when planning for retirement.

The first risk was longevity risk which we will tackle by ensuring we comply with the 4% safe withdrawal rate and we will make sure we have the appropriate level of insurance to cover any catastrophic medical or lifestyle event to protect our portfolio.

The second risk was behavior risk which we are going to deal with by ignoring the news, ignoring hot stock tips, and any other investment advise. We have an investment plan mapped out already and we are not going to compromise it by making changes mid-stream.

The final risk is the most important; sequence risk which we are going to take by taking a laddered risk approach. We are going to go all-in on high risk stock indices in our 20’s and 30’s and then in our 40’s and 50’s we are going to slowly decrease our stocks allocation so that we never put our retirement at risk from a decade or more long bear market.