Planners look at the critical zone in the five years before and after retirement.

    Patricia Barrett, a financial advisor with Lifetime Planning LLC in Houston, recently illuminated one of the mistakes that people can make when planning for their retirement-a case of water, water everywhere, and nothing to drink.

"I've got a recently retired individual going through a divorce, and his financial planner put all his liquid assets in annuities-a million and a half in variable annuities," she says. "Now, as a divorced individual, I don't know where to find him income, because his money is locked up. He will have to pay fees to get his own money out. A man with a million and a half in annuities and nothing to live on. I can't believe his financial advisors did that. We're cashing in his life insurance cash value, about $150,000, for first-year expenses."

There are other horror stories, too. Of course tales run rampant about those who had their savings wiped out by the 2001 bear market. Or had money tied up in their company's stock (an object lesson of the Enron scandal).

Prudential Financial put out a report in 2006 christening the five years before and after retirement as the "retirement red zone," a time of critical decision making when newly freed workers are free to make dramatic blunders affecting their golden years. The Society of Actuaries identified 15 risks people face in the period right after they receive their gold watch-including the financial effects of living longer, the daunting challenges of higher health-care costs, the risk of inflation (and its corollary of lost purchasing power), as well as the risk of stock market shocks.

The latter is one of the most misunderstood risks, as downturns in the first few years just after retirement can be much more devastating than those farther out. "Losing 29% in the 29th year out of 30 is not as devastating as losing it in the first year out of 30," says Michael Kitces, with Pinnacle Advisory Group Inc. in Columbia, Md.

It's an important time because their clients make decisions irrevocable in nature, ones that will dog them for another 30 years. Choices based on emotion, lack of education and procrastination.

"I think it's a critical time because of compounding," says William Garrett, president of Garrett Financial LLC in Brentwood, Tenn., who specializes in cash-flow management issues with retirees. "And if a person takes a disproportionate amount out of savings in the first few years, it can make a drastic difference in how much they have to work with, given the typical average rate of returns on assets later on. It's much better to have a larger pool in the beginning to grow out of, and take less out of it, than to do it in reverse."
Because of the importance of the money in the earliest years, Garrett thinks it's important to often supplement those savings with extra income so they don't erode at this critical time. And yet, the time right after retirement is usually the time when people want to travel and splurge.
As Garrett sees it, human longevity has been both a blessing and a curse: Retirees might be looking at a longer, more fulfilling life, but they'll also need their retirement assets to work longer and harder. And ironically, the plan is often to move into bonds-the kind of strategy meant for a shorter time horizon, not a long one. Still, if you tell retirees that they should be in equities-maybe by as much as 50% to 75%, according to some studies-it's more than they can bear.

"If you have a second-to-die expectancy of 25 years, the after-tax return on bonds is equal to inflation," says Don Mulvihill, managing director at Goldman Sachs based in Chicago and a portfolio manager of the Structured Tax-Managed Equity Fund and the U.S. Equity Dividend and Premium Fund. "If the goal is to provide something for spending while also keeping up with inflation, bonds won't do it."

Getting Emotional

It's the rash decisions that are the most important things planners say they have to manage around this time. "Clients who were dependable and did everything you asked for ten years are suddenly more emotional," says G. Joseph Votava Jr., president of Nixon Peabody Financial Advisors LLC in Washington, D.C. "You must check in with them and make sure they're doing what they said they were going to do."

However, the picture of retirement has changed, too. Many people don't want to go sit on the porch, but keep working, maybe find something that interests them more. Though many want to travel, they might get that out of their system in a year or two. This means they could be willing to earn more income and shore up the money they need to work harder in those crucial first years, because after that they face the later years and the looming shadow of higher medical bills.

"In the five years prior to actually retiring, it's important that somebody go through some sort of coaching or counseling to decide what they want their retirement to be like," says Gala Gorman, a wealth manager with Five Points Financial in Franklin, Tenn. "It's easy to say, well, I can live on $8,000 a month, but if you've been a type A personality, you're bored stiff. Who cares if you've got $8,000 coming in? You're looking for something to do, and that takes some capital infusion-and out the window goes your financial plan."

Ken Shapiro, a planner with Shapiro Financial Security Group Inc. in Hazlet, N.J., recalls a retired client who didn't want to own a house ever again, and who locked her money in an annuity ... and then found that perfect cottage she wanted while driving down the road. "The market had gone through the downturn, and she had surrender charges and fees for the annuity," he says. "It cost her a pretty penny as well as the lost principal."

Probably the biggest mistake is that many have not girded themselves for life-altering events. The prescription, say planners? Defer major decisions (huge trips, or a new business) if you don't have a plan, and spend the first few years figuring out what retirement is about. To many planners, this is more important than dramatic portfolio changes-figuring out client goals and tweaking the financial picture accordingly.

Saving Too Much?

Some academics have recently taken the counterintuitive argument that people are saving too much, mainly at the behest of the financial services industry. Shapiro questions this logic, however, saying that most people need the extra cushion because they are underinsured and face higher medical and college costs. What's more, they're managing their own money more in this post-defined-benefit world, sometimes to their detriment.

"People are putting so much away on a tax-deferred basis that they have no liquidity," says Shapiro, "And every time they need money to buy a car or make some type of acquisition or take care of an emergency, then they're having to take money out of whatever retirement vehicle they have. And every time they do that, there is a tax consequence increasing the cost of that transaction."

For many advisors, the switch from offense to defense-from accumulation to protection-is why they prefer laddered bond portfolios, which allow clients to draw income. Shapiro, who used to work in banking, says that for him the key is asset-liability matching, and laddered bonds allow him and others to fund client needs in the first five years so that he knows those funds will be there no matter what the market does. By segregating these assets, he says, clients become more comfortable with the risk of longer-term investments.

"I tried to use that in designing portfolios, so what clients were not going to need for 15 years we could invest more aggressively," he says. "I say we're going to carve out $50,000 or $100,000 or whatever the case may be for that portfolio and make that purely a fixed-income laddered maturity instead of funding it from capital gains."

Another thing that's important to do, says Shapiro, is to make sure that the clients know it is OK to hold liabilities as long as assets are growing faster. This is a key argument for a retiree who feels an emotional need to be free of debt.

"If you have a mortgage at 6% and you're earning 7% on your portfolio, then every year your net worth is going up 1% and you're making money off someone else's money," he says. "If you had no debt, you wouldn't have that 6% cost, but you also wouldn't have the funds with a 7% growth."

Not Enough? Now What?

If the clients haven't saved enough, the answers are less clear cut. Sometimes it means that they will have to drastically reduce expenses, and in some cases it may mean putting off retirement.

"If a person hasn't saved enough, it's the old guns and butter," says Keith Singer, a planner in Plantation, Fla. "You only have so many resources to do some things. You can either work longer, spend less or take more risk. Three choices. The risk is really running out of money because you spend too much." In some cases, that means that the client will get back on track if they defer retirement by a couple of years. In some cases, a guaranteed income from an annuity product will be in order, though planners are often careful when prescribing these since they are often sold inappropriately (at a high fee to the seller) to capture risk that the client doesn't have.

This argument eventually leads to a thornier debate about the optimal rates of withdrawal for a retirement portfolio, and that's where opinions start to diverge. According to figures in an oft-quoted study by the Department of Business Administration at Trinity University in the late 1990s, the conventional wisdom that a retiree can take a 7% annualized withdrawal from a portfolio with 50% equities and 50% bonds can be dicey if you're afraid of inflation eating away purchasing power. According to the study, Sustainable Withdrawal Rates From Your Retirement Portfolio by Philip L. Cooley, Carl M. Hubbard and Daniel T. Walz, the portfolio success rate of inflation-adjusted monthly withdrawals over 30-year rolling periods from 1926 to 1997 was just 19% for 7% annualized withdrawals.

"What I was struck by," says William Garrett referring to the Trinity research, "is at a 6% beginning withdrawal rate-this is the portfolio returns since World War II, taking the Depression out of the thing-at 6%, which is the pretty common amount of what people want to take out, 43% of those portfolios didn't make it 30 years. Some of them were substantially less than 30 years. ... We start off making some false assumptions-that since the S&P 500 has made 10% a year and inflation has been 3% a year, I can take 7% a year out of a portfolio and I can be okay. But the study points out that that's a myth."

Garrett went back and took his own look at underlying figures by Ibbotson Associates through 2004. He found that since 1925, large-caps and small-caps combined have lost money 31% of the time over one-year rolling periods; over five years they've lost money 13% of the time; and over ten-year periods they've lost money 3% of the time. (Only the rolling 20-year periods didn't lose money.)   

He says that his research-not only these figures, but also the higher 3.4% inflation risk calculated for the elderly-have convinced him that it is hard for bonds to keep up, and so he has stretched out his bond ladders to ten years as part of a proprietary method he has developed for constructing model portfolios. That way, he says, the money that replenishes the ladder from the stock market is allowed to stay in the market longer. Rather than being a traditional ladder that consumes principal, Garrett's structure includes an income pool with interest-bearing obligations of staggered maturities, including bonds, money market CDs, fixed annuities, etc.-anything that provides a dependable income stream without risk of market loss.
"The biggest problem I see with bond ladders is that they require so much money to generate enough income," he explains. "For instance, if you make 5% and you want a $50,000-a-year retirement income-do the math. You've got to have a million in there. Most baby boomers don't have that."

He says he would rather keep that money in the market, because there's less risk in the ten-year holding period. "So if you look at it in historical terms, you've reduced risk from a one-year rolling period of 31% to a ten-year rolling period of 3%. You've reduced risk by 90%. And that's a lot more optimal holding period for a bond ladder, in my estimation."

Cooley, one of the authors of the research, says that these figures are correct. However, he thinks a 7% withdrawal rate still can be successful if the figures are not adjusted for inflation (the consumer price index).

"I don't like CPI-adjusted figures," Cooley says, "because if you do the math, you'll find that you're back-end-loading all the spending, when the [retirees] are not as vital and not likely to be spending as much. If the market is doing well, it is possible for a retiree to give himself a raise, and if the market is doing poorly, as it was in 2000, then it's time to scale back."

Familiar Mistakes

Besides stressing to their clients that they must use the engine of compounding, and judiciously allocate between tax-deferred and nontax-deferred accounts, planners also must illuminate the simple pitfalls and tripwires awaiting the unwary retiree navigating the ups and downs of the golden years. An oft-told story is the one about the retiree who, like a parolee newly sprung, fled his office without remembering to exercise incentive stock options.

"The maximum period of time you have to exercise an incentive stock option is three months," says Shapiro. "I heard one story about a guy who was so excited he went on a cruise for a month or six weeks, and it took him three or four months after retirement to get his financial affairs in order. So he went on his cruise and forfeited all the value he built up on those stock options."

Another recommendation is to start cashing out of positions in their tax-deferred plans as they approach retirement, between two years and a year before leaving. "Put it in a guaranteed income or guaranteed interest account," says Garrett. "Don't worry about possible lost returns in that last year. ... It's not worth the chance that investments in a 401(k) will take a huge dive about the time you get ready to retire. I've seen this firsthand, when people come in and they've had employer stock-when that happened in 2000, I saw people who came in during April, May or June holding 50% of their assets in 401(k) in employer stock. They didn't have the choice to diversify. That was the company's match. And there was the bear market staring them in the face, and the stock dropped from $53 to as low as $17 over the next three years."