Aug 25, 2021

3 Unforeseen Investment Mistakes Pre-Retirees Often Make

Three Unforeseen Investment Risks for Pre-Retirees

It’s not uncommon for me as a Financial Advisor to sit down with a prospect who has already run their own analysis on their upcoming retirement. There are a number of tools readily available that will, perhaps, give a pre-retiree a false sense of security when it comes to making their money last. While these tools can be helpful in some instances, they can also be dangerous. There are a number of considerations we look at when planning for people, considerations they probably haven’t thought about. For the purposes of this article, let’s unpack three important ones.

Sequence of Return Risk

More often than not, while running their own retirement scenarios, investors tend to use a static return they assume they’ll achieve each year. For this example, let’s take 7%. We know each market year produces different market returns, and we don’t know what the future holds. However, the most important piece of this puzzle is what we call “sequence of return risk.” What this means is that different returns at different periods of time in your retirement can make a huge difference in your overall return. Consider the following example of a $1,000,000 portfolio getting varying market returns that average out to 7% at the end. The hypothetical withdrawal rate in this example is around 4% on the portfolio, and let’s also assume a 3% inflation rate because (as we’ve seen especially this year) food, vacations, services, etc. tend to get more expensive through the years.
Rate of Return Year Portfolio Value Yearly Withdrawal
0 $ 1,000,000.00
21.53% 1 $ 1,175,311.62 $ 40,000.00
0.99% 2 $ 1,145,695.98 $ 41,200.00
13.20% 3 $ 1,254,449.30 $ 42,436.00
-5.08% 4 $ 1,147,002.59 $ 43,709.08
-8.66% 5 $ 1,002,613.95 $ 45,020.35
7.23% 6 $ 1,028,779.92 $ 46,370.96
12.84% 7 $ 1,113,080.06 $ 47,762.09
12.82% 8 $ 1,206,572.69 $ 49,194.95
-0.12% 9 $ 1,154,406.89 $ 50,670.80
21.35% 10 $ 1,348,731.76 $ 52,190.93
5.94% 11 $ 1,375,103.36 $ 53,756.66
9.05% 12 $ 1,444,128.98 $ 55,369.35
-2.76% 13 $ 1,347,264.13 $ 57,030.44
7.67% 14 $ 1,391,813.56 $ 58,741.35
10.51% 15 $ 1,477,630.31 $ 60,503.59
-10.99% 16 $ 1,252,933.49 $ 62,318.70
7.39% 17 $ 1,281,344.14 $ 64,188.26
12.84% 18 $ 1,379,731.74 $ 66,113.91
12.45% 19 $ 1,483,476.52 $ 68,097.32
6.32% 20 $ 1,507,055.77 $ 70,140.24
-11.31% 21 $ 1,264,336.44 $ 72,244.45
15.89% 22 $ 1,390,821.87 $ 74,411.78
36.29% 23 $ 1,818,976.28 $ 76,644.14
-4.40% 24 $ 1,659,990.87 $ 78,943.46
25.11% 25 $ 1,995,480.39 $ 81,311.76
-5.39% 26 $ 1,804,239.38 $ 83,751.12
5.33% 27 $ 1,814,169.95 $ 86,263.65
12.52% 28 $ 1,952,542.30 $ 88,851.56
19.11% 29 $ 2,234,242.50 $ 91,517.11
-17.68% 30 $ 1,745,060.21 $ 94,262.62
7.00% $ 1,745,060.21
In Scenario 1, things seem to have worked out pretty well for our hypothetical retiree. They were able to spend what they wanted and were left with more money than when they started. Now let’s look at a second scenario, where we’ll change just two variables. We’re going to move the year-30 return of -17.68% to year 1 of retirement, and we’ll also take the year-16 return of -10.99% and move it to year 2 of retirement. Let’s take a peek at what happens now. We’re still assuming an average 7% return at the end, but those two negative returns are now placed at the beginning of retirement.
Rate of Return Year Portfolio Value Yearly Withdrawal
0 $ 1,000,000.00
-17.68% 1 $ 783,242.25 $ 40,000.00
-10.99% 2 $ 655,971.06 $ 41,200.00
21.53% 3 $ 754,773.25 $ 42,436.00
0.99% 4 $ 718,503.53 $ 43,709.08
13.20% 5 $ 768,298.95 $ 45,020.35
-5.08% 6 $ 682,891.30 $ 46,370.96
-8.66% 7 $ 575,968.28 $ 47,762.09
7.23% 8 $ 568,443.37 $ 49,194.95
12.84% 9 $ 590,742.40 $ 50,670.80
12.82% 10 $ 614,279.73 $ 52,190.93
-0.12% 11 $ 559,761.95 $ 53,756.66
21.35% 12 $ 623,925.98 $ 55,369.35
5.94% 13 $ 603,963.03 $ 57,030.44
9.05% 14 $ 599,857.56 $ 58,741.35
-2.76% 15 $ 522,807.68 $ 60,503.59
7.67% 16 $ 500,571.11 $ 62,318.70
10.51% 17 $ 489,007.52 $ 64,188.26
7.39% 18 $ 459,034.05 $ 66,113.91
12.84% 19 $ 449,868.44 $ 68,097.32
12.45% 20 $ 435,758.17 $ 70,140.24
6.32% 21 $ 391,043.00 $ 72,244.45
-11.31% 22 $ 272,397.28 $ 74,411.78
15.89% 23 $ 239,035.81 $ 76,644.14
36.29% 24 $ 246,850.35 $ 78,943.46
-4.40% 25 $ 154,676.23 $ 81,311.76
25.11% 26 $ 109,762.22 $ 83,751.12
-5.39% 27 $ 17,586.04 $ 86,263.65
5.33% 28 $ (70,327.91) $ 88,851.56
12.52% 29 $ (170,653.55) $ 91,517.11
19.11% 30 $ (297,535.62) $ 94,262.62
7.00% $ (297,535.62)
The sequence of investment returns has dramatically impacted the retirement of our hypothetical retiree. By achieving bad investment results early in retirement, our retiree immediately fell below the initial $1,000,000 investment and never again had a portfolio worth that much even after returns improved in years 3, 4 and 5. Additionally, while the first scenario took our retiree through 30 years comfortably, the second case - with the bad returns early - ran out of money early in year 28. While these scenarios are not meant to make our clients and prospects fearful, being able to plan for bad returns early on in retirement with a sound strategy is an integral part of our planning.  Which leads into investment risk #2…

Funding Cash Needs in Retirement

A very overlooked piece to a well-thought-out retirement plan is where to draw money from for cash needs in retirement. While the paychecks will inevitably stop coming, the living expenses do not. In some regards, retirement is more about spending than it is about investing. Many “do-it-yourselfers” may be prone to sell equities to fund their cash needs, or take some from equities and some from bonds to produce their much-needed cash flow. Similarly, many financial practitioners will also sell both equities and bonds to fund their clients’ cash need. During periods of higher returns and bull markets, this strategy could work – but history has told us recessions have hit us and will continue to come… and almost all the time, we cannot predict when these periods hit. It’s of the utmost importance to be properly allocated, but we at Baird Retirement Management take it a step further by showing our pre-retirees and retirees real-world data on why drawing cash from certain asset classes will help our clients weather the storms that we cannot avoid.

Asset Location

While it’s certainly not the last thing we see investors overlook, for purposes of this article I’ll end with “asset location.” What do we mean by asset location? Not all dollars are created equal, and that becomes especially true in retirement. The way tax-deferred accounts and post-tax accounts are treated from a tax perspective is very different, and we at Baird Retirement Management also feel the investments that go into these buckets should be treated differently as well. Many investors will overlook the need to do a deep dive on the most tax-efficient way to invest in retirement. For us at Baird Retirement Management, this goes deeper than just choosing a municipal bond fund over a corporate bond fund. With each pre-retiree’s unique situation, we analyze the types of dollars in the portfolio and form well-thought out planning on what makes the most sense from an asset location standpoint. Where should dividend-paying equities be placed? How about growth stocks? Do mutual funds or individual stock portfolios make more sense and, if so, why?  What we have found is that there’s a real “ah-ha” moment from our clients and prospects in this particular stage of our planning – and it’s something many people will not think of: What are the most tax-efficient investments I can have while also achieving my goals in retirement? We’ve covered three of the most common unforeseen investment risks to pre-retirees in this article. While there are many more that can easily be discovered by working with the right financial practitioners, these three in particular are ones we really focus on at Baird Retirement Management – and our thousands of current clients continue to thank us for it. All investments carry a level of risk, including loss of principal. Robert W. Baird & Co Incorporated does not provide tax or legal advice.  


Contact Us

To set up a meeting with a member of the
Baird Retirement Management team