The 10 most important years of your retirement plan

Before you go, we thought you'd like these...
Before you go close icon

As you get close to your retirement, one 10-year span matters more to your success than any other. That span starts five years before you retire and runs through five years after you call it quits. That 10-year window is critical because it plays a huge part in determining both how much you'll have available to spend in your retirement and how likely it is that your nest egg will last as long as you do.

In the five years before you retire, you'll want to set yourself up so that you'll be able to take withdrawals once you retire, without putting the money you need to spend at unnecessary risk. In the five years after you retire, you'll want to balance your need for money to spend on your costs of living with your need for money to invest to support the later years of your retirement. If you handle both five-year periods well, you'll set yourself up well for success throughout the rest of your retirement.

What happens if you get it wrong?

To illustrate why those years are so critical, imagine someone who made some serious money during the late 1990s technology boom and decided to retire on January 1, 2000. This retiree, not knowing any better, decided to stick with what had worked so well and retired with a portfolio made up of the tech titans that created that paper fortune.

Discover the average retirement age in every state:

51 PHOTOS
Average retirement age in every state
See Gallery
Average retirement age in every state

Alabama - Age 62

Via Smart Asset

Photo: Getty

Alaska - Age 65

Via Smart Asset

Photo: Getty

Arizona - Age 63

Via Smart Asset

Photo: Getty

Arkansas - Age 62

Via Smart Asset

Photo: Getty

California - Age 64

Via Smart Asset

Photo: Getty

Colorado - Age 64

Via Smart Asset

Photo: Getty

Delaware - Age 62

Via Smart Asset

Photo: Getty

Connecticut - Age 64

Via Smart Asset

Photo: Getty

Florida - Age 63

Via Smart Asset

Photo: Getty

Georgia - Age 62

Via Smart Asset

Photo: Getty

Hawaii - Age 63

Via Smart Asset

Photo: Getty

Idaho - Age 63

Via Smart Asset

Photo: Getty

Illinois - Age 63

Via Smart Asset

Photo: Getty

Indiana - Age 63

Via Smart Asset

Photo: Getty

Iowa - Age 64

Via Smart Asset

Photo: Getty

Kansas - Age 65

Via Smart Asset

Photo: Getty

Kentucky - Age 62

Via Smart Asset

Photo: Getty

Louisiana - Age 63

Via Smart Asset

Photo: Getty

Maine - Age 64

Via Smart Asset

Photo: Getty

Maryland - Age 64

Via Smart Asset

Photo: Getty

Massachusetts - Age 64

Via Smart Asset

Photo: Getty

Michigan - Age 62

Via Smart Asset

Photo: Getty

Minnesota - Age 63

Via Smart Asset

Photo: Getty

Mississippi - Age 63

Via Smart Asset

Photo: Getty

Missouri - Age 63

Via Smart Asset

Photo: Getty

Montana - Age 63

Via Smart Asset

Photo: Getty

Nebraska - Age 65

Via Smart Asset

Photo: Getty

Nevada - Age 63

Via Smart Asset

Photo: Getty

New Hampshire - Age 65

Via Smart Asset

Photo: Getty

New Jersey - Age 65

Via Smart Asset

Photo: Getty

New Mexico - Age 63

Via Smart Asset

Photo: Getty

New York - Age 64

Via Smart Asset

Photo: Getty

North Carolina - Age 63

Via Smart Asset

Photo: Getty

North Dakota - Age 63

Via Smart Asset

Photo: Getty

Ohio - Age 63

Via Smart Asset

Photo: Getty

Oklahoma - Age 63

Via Smart Asset

Photo: Getty

Oregon - Age 63

Via Smart Asset

Photo: Getty

Pennsylvania - Age 63

Via Smart Asset

Photo: Getty

Rhode Island - Age 64

Via Smart Asset

Photo: Getty

South Carolina - Age 62

Via Smart Asset

Photo: Getty

South Dakota - Age 63

Via Smart Asset

Photo: Getty

Tennessee - Age 63

Via Smart Asset

Photo: Getty

Texas - Age 64

Via Smart Asset

Photo: Getty

Utah - Age 65

Via Smart Asset

Photo: Getty

Vermont - Age 65

Via Smart Asset

Photo: Getty

Virginia - Age 63

Via Smart Asset

Photo: Getty

Washington - Age 64

Via Smart Asset

Photo: Getty

West Virginia - Age 62

Via Smart Asset

Photo: Getty

Wisconsin - Age 63

Via Smart Asset

Photo: Getty

Wyoming - Age 65

Via Smart Asset

Photo: Getty

of
SEE ALL
BACK TO SLIDE
SHOW CAPTION +
HIDE CAPTION

Assume that person had a $1 million portfolio entirely invested in the PowerShares QQQ(NASDAQ: QQQ) Exchange traded fund made up of 100 of the largest non-financial NASDAQ-traded companies. Thanks to that design, the PowerShares QQQ ETF represents a technology-heavy investment.

In those heady days, many people had a mistaken belief that stocks -- particularly tech stocks -- could only go up. If that retiree thought the tech boom would never end and stayed invested in the PowerShares QQQ ETF, the chart below shows what could have happened to that retiree's portfolio over the next decade:

Date

Portfolio Starting Value

Action

Withdrawal

Portfolio Ending Value

1/1/2000

$1,000,000

Take out spending cash

$40,000

$960,000

1/1/2001

$613,297

Take out spending cash

$41,138

$572,159

1/1/2002

$381,374

Take out spending cash

$41,789

$339,585

1/1/2003

$212,688

Take out spending cash

$42,741

$169,947

1/1/2004

$254,357

Take out spending cash

$43,879

$210,478

1/1/2005

$232,665

Take out spending cash

$45,366

$187,299

1/1/2006

$190,234

Take out spending cash

$46,829

$143,405

1/1/2007

$153,650

Take out spending cash

$48,163

$105,486

1/1/2008

$125,555

Take out spending cash

$50,012

$75,542

1/1/2009

$44,019

Take out spending cash

$49,834

($5,815)

Data sources: ETF data from Yahoo! Finance and inflation data from the U.S. Bureau of Labor Statistics. Assumes no friction costs and that all dividend/gains distributions are reinvested.

While the PowerShares QQQ ETF did eventually top the price it saw late in the tech boom, it was too little, too late for our retiree friend, who ran out of cash within nine years of retiring. The key difference between a retiree and a working investor is the fact that most retirees need to take out cash to cover living costs, while a working investor has a job to cover those daily costs of living.

It's not as though our hypothetical retiree was being unreasonable with that initial withdrawal plan. The chart above starts with a $40,000 withdrawal from a $1,000,000 portfolio and increases the withdrawals for inflation each year. Those guideposts are key parts of a common retirement guideline known as the 4% rule. The key difference is that the standard 4% rule presumes the investor starts with a diversified stock- and bond-based portfolio, while our unfortunate retiree was 100% invested in stocks.

How to use those 10 years to your advantage

The key to your ultimate success in retirement is having a source of spending cash that has a high likelihood of actually being there for you when you need it. A key guideline for any investor wanting to avoid the scenario described above is to not have any money in stocks that you expect to spend within the next five or so years.

As a result, beginning at least five years before you retire, you need to start converting some of your money from stocks to bonds. How much? Enough so that when you do retire, you have sufficient cash to cover your spending needs. A common way to do that with bonds is via a strategy known as a "bond ladder."

Since bonds eventually mature and pay back their face value as cash, investors creating a bond ladder would buy bonds that mature on a regular cycle, so they'll have cash available when they need it. If you buy investment-grade bonds that mature in five years about five years before your retirement, when it comes time to retire, you'll have cash from those maturing bonds.

To turn that tactic into a bond ladder, when you're four years before retirement, convert another year's worth of living expenses into five-year investment-grade bonds. In so doing, your original set of bonds will have four years until maturity. Repeat the process every year, up until just before you retire.

At that point, you'll have a year's worth of spending cash coming in from your maturing bonds, plus another five years' worth of spending cash coming in when those other investment-grade bonds mature. The rest of your portfolio can stay in stocks, and you'll be much better equipped to handle the ups and downs of the stock market, simply because you won't have to sell your stocks to cover your immediate costs of living.

Keep it up throughout your retirement

By following this strategy, you set yourself up to have a very strong likelihood of success during those critically important 10 years of your retirement plan. Even better, it's a strategy you can keep up throughout your retirement.

If the market performs as expected, you can keep converting your stocks to bonds each year to keep your bond ladder going strong. If the market performs exceptionally well, you can extend your bond ladder to give you an even greater buffer. And if the market performs poorly, you're under no immediate obligation to sell your stocks to cover your costs of living, and you can let that bond ladder shrink a bit.

If you do have to shrink your bond ladder because of a poor market, just be sure to build back toward that target of at least five years in your bond ladder over time. That way, you retain the flexibility to not have to sell your stocks in a bad market just to cover your costs of living. When all is said and done, that's one of the most important things you can do as a retiree to improve your chances of seeing your nest egg last as long as your retirement does.

RELATED: Check out the 10 best states for retirement:

11 PHOTOS
Best states for retirement
See Gallery
Best states for retirement

1. South Dakota

Photo: Getty

2. Iowa

Photo: Getty

3. Minnesota

Photo: Getty

4. Alaska 

Photo: Getty

5. Oregon 

Photo: Getty

6. Colorado

Photo: Getty

7. Hawaii 

Photo: Getty

8. South Carolina

Photo: Getty

9. Nebraska

Photo: Getty

10. Wisconsin

Photo: Getty

of
SEE ALL
BACK TO SLIDE
SHOW CAPTION +
HIDE CAPTION

The $15,834 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: One easy trick could pay you as much as $15,834 more...each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.

Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read Full Story

Want more news like this?

Sign up for Finance Report by AOL and get everything from business news to personal finance tips delivered directly to your inbox daily!

Subscribe to our other newsletters

Emails may offer personalized content or ads. Learn more. You may unsubscribe any time.

From Our Partners