Three Ways to Avoid The Retirement Transition Trap

By Ed Mahaffy, CFP, Founder of ClientFirst Wealth, Legacy & Estate Planning

A 2024 YCharts Advisor-Client Communication Survey found that 75% of clients either switched advisors or considered switching advisors during 2023. Major life transitions can trigger a reassessment of financial relationships and retirement is one of the most significant life transitions a person experiences. Considering an experienced retirement advisor---one who exclusively serves retirees and those nearing retirement and who does not sell products--- can make sense as they have likely helped many retirees in similar circumstances.   

Often investors are not well served by maintaining the same financial advisor throughout their whole life. Why? Because the investment and financial planning playbook during an investor’s accumulation phase is vastly different from that of their distribution phase-- where their savings must be converted to a reliable retirement paycheck and tax planning becomes more important than trying to squeeze a few extra points from the market.

The two years before a person retires and the three following that milestone can be what I have coined the “retirement transition trap.” This is the time when poor market returns early on can force you to sell at depressed prices to fund your lifestyle. And as markets eventually recover, your account may not because you have fewer dollars invested. The damage suffered in the transition trap can be permanent and can ultimately threaten income sustainability.

Here are three steps an investor can take to protect yourself:

1. Recognize the unique risks presented during the early years of retirement.

These include things like sequence of returns risk where poor market returns can quickly eat up a retiree’s savings if not managed properly. 

Or another problem I find with some clients is that they go on a bit of a spending spree early on in retirement – booking trips or buying the expensive car they always wanted. There’s nothing wrong with retirees enjoying the fruits of their labor, but when increased spending coincides with poor market returns, financial assets are forced to carry twice the burden.      

Taxes can also be an early retirement issue without proper planning. Retirees must plan for which accounts to draw from and in what order. Distributions from tax-deferred accounts which are treated as ordinary income, can unnecessarily push you into higher income tax brackets as well as trigger Medicare premium surcharges.   

2. Build a plan designed to withstand market volatility

Let’s be honest – when the market goes down, it takes just about everyone with it. The key here is to seek to reduce downside risk where possible, although all investments involve risk and losses can still occur. 

How can that be done? The bucket strategy. One bucket to cover several years of living expenses. Investments might include money market funds, and T-bills, for instance. Another bucket holds income-generating investments, such as 3- to-7- year Treasury notes, or other short- to- medium term fixed-income securities, and a third bucket holds equities and other assets with long-term growth potential. This way when the market takes a spill, you have the comfort of knowing you have three years of living expenses set aside and income-generating securities to replenish it as needed. Any urge to panic sell may be reduced for some investors, although outcomes will vary and cannot be guaranteed. Your equity portfolio may remain invested and may be better positioned to participate if markets recover, but recovery timing and investment outcomes are uncertain.

3. Structure income carefully

When a person retires, this is the first time they’re not getting that weekly, bi-weekly, or monthly paycheck. It truly is a tricky transition to go from knowing how much a person can spend in a month without going into debt and instead having a pile of cash that needs to last the remainder of their life. But that’s why, whether on their own or with a financial advisor, retirees should have a written income plan with reasonable spending guardrails. 

Retirement truly is one of the most significant life transitions a person experiences. People who anticipate they will stop working on a Friday and wake up on Saturday knowing how to perfectly spend the rest of their days without planning and forethought are kidding themselves. Retirees may approach retirement with greater confidence through strategic and thoughtful preparation.