Managing Possible Perils in Retirement Transition

One of the greatest risks we face as investors transitioning into retirement is often not discussed at all—and if it is, it’s typically by a smooth-talking salesperson trying to sell an annuity that may not be in your best interest. In financial terms, this risk is referred to as sequence-of-returns risk. It simply means that we should not trust the average. This concept is crucial as we prepare for and transition into retirement.

Simply put, an average return may look acceptable over the long term. however, hidden in the data set may be very unfavorable years. Does anyone remember 2000, 2008, 2018, or 2022? Most portfolios still averaged a fair rate of return across those years. The problem arises when those down years occur near retirement—either just before or just after. This timing can devastate a financial plan, because early on, you are often selling assets to create income at a much faster pace than your portfolio can recover. To be fair, if you have “knock-it-out-of-the-park” years early on, they can give your plan a significant boost. Risk almost always cuts both ways.

The key to managing this risk is to run a portfolio, both leading up to retirement and in the early years of retirement, that tightens the distribution probability of outcomes. In plain English: reduce volatility—commonly referred to by financial advisors as risk. For three decades beginning in the 1980s, the easy solution was simply to own more bonds, which produced solid returns and smoothed out stock-market swings. However, that period benefited from a long secular trend of declining interest rates, which allowed bonds to generate stock-like returns in many years.

A fundamental shift occurred in 2020 that changed how bonds function inside a portfolio. They stopped acting as reliable hedges and became riskier, low-expected-return assets. The problem is that if your financial plan calls for a 7–9 percent expected rate of return over the life of the plan, most bond index funds will likely fall short. Their yields are still too low. Over-allocating to bonds early on can drag down long-term returns and still place the entire plan at risk.

One solution worth considering is a high-yielding structured note. These notes are often custom-designed to meet investor needs in terms of return expectations and risk profiles. The downside is that they are usually less liquid. However, adding this type of allocation in a retirement plan can provide a stock-market-like yield with endogenous return—meaning the return is generated within the contract itself and is not entirely subject to the same market forces that drive stock performance. The value lies in meeting long-term return expectations while generating current income and tightening the expected-return distribution curve.

Structured notes are not without their own flaws though. Potential illiquidity is often the largest, but they do still carry risk as does any investment. They are subject to losses that vary depending on how your financial advisor designs them. They are also tax inefficient, as are almost all income producing investments.

A final risk investors should be aware of is that in order for these investments to produce an expected return in the form of income payments, they forgo the ability to participate in the upward movement of the broader stock market over time. In my opinion, this is one of the main reasons why these are not ideal fits for most people in the growth phase of life or for investors deep into retirement with less sequence of returns risk.

As always when dealing with a more complicated financial instrument and the nuances of your own plan, ensure you work with a trusted fiduciary investment advisor and financial planner that can help you navigate your own unique situation while acting in your best interest at all times.