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The retirement “red zone” describes the important 10-year period surrounding your retirement date — five years before and the first five years after you retire.
That’s a critical time because sequence of returns risk and market downturns can harm a portfolio when withdrawals begin, resulting in a potentially drastic reduction of funds over the course of retirement.
Many people in the retirement red zone have saved enough money. Some also have taken on much more risk than they realize.
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Anyone in the 55- to 65-year-old pre-retirement window will likely need to take a different investment approach as they get closer to retirement.
The first step is to determine how much risk they’re willing to take. The next step is to see how much risk they’re actually taking in their 401(k) or other investments.
What we’ve found at my firm is that it’s very common for individuals within this critical retirement red zone to be taking on significantly more risk than they want or are comfortable with.
That common scenario is unnecessary for those who have saved enough for their needs and goals in retirement.
Find your comfort level with risk and act
A risk analysis can help individuals in the retirement red zone assess whether the amount of risk in their portfolio reflects the level of risk they’re truly comfortable taking.
Many great retirement tools have been devised to analyze and de-risk your portfolio as you get closer to your projected retirement date. But many people don’t use those tools or even know they exist. They still pick investments themselves, and the result is they end up with far more risk than they want or even realize.
It’s essential to know the rules of investment change once people begin withdrawing money from their retirement accounts. The primary problem is the sequence of returns risk: The danger that poor investment returns early in retirement, combined with regular withdrawals, can deplete your savings faster than expected, even with later market rebounds.
It’s about the timing of returns (a bad sequence) vs the average return, because early losses lock in lower capital, making it harder for the portfolio to grow and meet income needs in the long term.
This risk is most significant for retirees because they have less time to recover losses.
A consistent, low-volatility 5% return, for example, can yield much more money than a volatile 7%, 8% or 9% return when withdrawals are being made. Understanding this concept is one of the most crucial things people must do as they approach retirement.
A risk analysis helps gauge an individual’s comfort level with potential losses and assist in developing asset allocation glide-path strategies for the final decade before retirement.
These plans adjust the investment mix over time, shifting from riskier, growth-focused assets to safer, income-producing assets as an individual’s strategy around wealth shifts from building to preserving as they approach the retirement red zone.
This approach balances the need for accessible funds with the goal of maximizing returns.
Here’s one example of how you can reduce and diversify your risk by splitting your money into three categories:
Protection (50%). Protection involves investing 50% of your assets in places where they can’t lose money (CDs, government securities, fixed annuities). These asset types tend to produce lower returns but preserve your principle.
The market (40%). The market involves investing 40% in stocks and bonds. This asset class tends to produce higher returns, but with that comes increased volatility as they can swing daily.
Many people view diversification as investing in stocks and bonds, such as the traditional 60/40 financial strategy (60% stocks for growth, 40% bonds for stability).
However, this strategy places all your investments in the market, therefore lacking the necessary protection. Still, it’s important to maintain some market exposure when reducing risk, because some of your savings must keep growing to outpace inflation in retirement.
Alternatives (10%). In this example, 10% of your assets are in alternatives such as real estate, debt securities, private equity and commodities, all of which are valuable for a balanced retirement plan because they offer diversification, a potential hedge against inflation and opportunities for stable income generation.
You deserve to retire with the lifestyle you want. Attaining your best level of financial security can largely depend on how well you plan to manage risk.
It’s critical as you approach retirement to rethink your relationship with risk and investing, seek expert advice, leverage retirement tools to analyze risk and take proper action to ensure you never get outside of your comfort zone.
Dan Dunkin contributed to this article.
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