The Criticality of the Decade Before You Retire

It's can easily be shown that for those who will be dependent on their own savings to fund their retirement, the decade preceding their retirement is the most critical for them reaching their investment goal.

For instance, let's assume that someone is planning on retiring at age 66. If this person's portfolio has fantastic returns from age 25-35, it's not likely to be very helpful since the size of the portfolio is still relatively small. Conversely, the portfolio is potentially reaching its peak size from age 57-66, so this is when portfolio returns have their biggest impact.

This issue is part of the problem referred to as sequence of returns risk. As an easy illustration, let's assume that I invest $1,000 every year for 10 years. In scenario A, my portfolio doubles in value after the first year and then returns nothing afterward. In scenario B, my portfolio doubles at the very end of the 10 years. While in scenario A, only the first $1,000 doubles, meaning that the final balance is $11,000, in scenario B, all $10,000 of my investment doubles, leaving the final balance at $20,000. Note that in both scenarios, the average annualized returns are 7.2%. But the timing of when those returns occurred varied had a dramatically impact on the final portfolio balance.

And that's a potentially big problem for many retirees, though many are oblivious to it. They have may dutifully contributed to their portfolio for many decades, but that last decade has an outsized effect on the size of their retirement savings.

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The criticality of the last decade before retirement for many folks is also compounded by the fact that job security, their health, and their immediate family members' health are also questionable for workers nearing traditional retirement age.

I've often heard financial planners discuss how people saving for retirement will be in 'great shape' to retire at something like age 66 if they keep up their contributions and their portfolio earns 7% real (i.e., above inflation) returns for the remainder of their time accumulating.

This sort of 'advice' literally makes me cringe.

What if their portfolio returns significantly less than 7% real?

What if they are forced to reduce the amount they are contributing to their portfolio?

What if they are effectively pushed out of the workforce (e.g., age discrimination)?

What if they become disabled?

What if they need to quit work to care for an ailing family member?

These risks are not rare. A portfolio of 60% U.S. stocks and 40% U.S. bonds barely kept pace with inflation from 2000-2009 and spent most of that time lagging inflation; to get close to 7% real returns, investors have historically needed a 100% stock portfolio, but this is too volatile for most workers in their 60s who are getting close to retirement.

On average, workers' peak earning year comes at age 45, and their earnings drop afterward. And around half of retirees got that way more or less involuntarily, most often due to losing their job (or being forced to take a big pay cut), their own health failing, or the failing health of a family member requiring their time and attention.

In other words, there is a lot that can easily derail a plan that requires 7% real returns and constant contributions to retirement savings all the way to age 66. The odds are actually against this plan succeeding. This reality should give those preparing for retirement pause.

However, there are a couple of courses of action that can be done to make one's financial plans for retirement more resilient. First, arranging one's affairs to attempt to become financially capable of retiring at a younger age, even if one does not choose to retire at that age, is a great strategy. For most, this will entail, at least in part, increasing their saving rate (i.e., saving and investing a greater proportion of their income).

Second, choosing an investment portfolio with a good track record of both relatively high and consistent returns can help to reduce the threat created by sequence of returns risk. Portfolio Charts has some fantastic tools (nearly all of which are free!) that can be used to evaluate how a specific portfolio would have performed over the last 50+ years, which might be a reasonable indication as to how it will perform going forward.

While workers' last decade of their careers has a big impact on their retirement savings that comes with big risks as well, steps can be taken to make one's retirement plans more resilient to such risks.