It’s hard enough planning for risks that could affect your current income. Start to think about potential risks to your income in retirement, and it’s harder still. Since many of the people I talk to aren’t aware of the risks to their current income, it would be hard to take the next step and think about risks to income in retirement. Consider the following retirement risks, and how you might plan ahead to help protect yourself.
Longevity retirement risk
Longevity is the most significant factor in retirement planning. More simply stated, it’s the risk that you will outlive your money. The longer you live, the more money you will need to draw down from income sources like Social Security, pensions, annuities, 401(k), IRA, and bank accounts. While you may want to Google life expectancy for a guesstimate of how long you may live, I caution that approach. There are many factors that may tilt those numbers in or out of favor, such as diabetes, if you’re a smoker, have high blood pressure, etc. The reality is no one can predict how long you’ll live.
Inflation retirement risk
Inflation is simply the fact that most things get more expensive the longer we live. It is typically more noticeable when there is a lengthy period between the purchase of an expensive item, such as a car or washing machine. These rising prices create an increased income demand. Travel that may have cost $500, may cost $1000 in the future. So if you spend $500 on a trip now, and want to take that same trip in retirement, you may need to earmark more money for it.
While one may see travel expenses as frivolous and discretionary, the cost of bread and milk rises with inflation, too. If your money doesn’t continue to grow, you’ll be forced into reduced consumption. And unfortunately, the actual rate of inflation is unknown, which means that we must guess what it might be in the future.
Market or investment risk
Market risk, or investing risk, occurs when your investments have a lower rate of return than you hoped. That return may even be negative. If you are using that (potentially shrinking) nest egg as a source of income and withdrawing money, then bouncing back from these types of draw downs is more difficult.
For example, a 20 percent decrease in your portfolio requires a 25 percent gain to recover back to even. So $100,000 dips down to $80,000, which requires you to earn a return of 25 percent on the $80,000 (a $20,000 gain) to get back to $100,000.
If you were retired and using that $100,000 for income, though, it would be even more significant. Say you took out 4 percent, or $4,000, at the beginning of the year. The 20 percent loss would take your balance from $96,000 to $76,800. You’d need a return of just over 30 percent to get back to $100,000. If the market was flat and you took another $4,000 the following year, you would now stand at $72,800. Now you would need a 37% return if you are hoping to get back to your original $100,000.
Tax rate risk
During my mother’s lifetime, the highest marginal income tax rate hit 90 percent. While she never made enough money to pay that rate, it’s not out of hand to predict future tax rates might go up significantly, particularly for higher tax brackets. Suffice it to say, we don’t know what income tax rates will be in the future. And of course, the amount you pay in taxes each year affects how long your savings might last.
Declining cognitive abilities risk
None of us wants to think about the possibility of declining cognitive abilities, though we’ve all heard terms like dementia and Alzheimer’s. With these risks as a possibility, it’s important that your retirement plan for generating income and budgeting it aren’t overly complicated. If the plan is complicated, find someone with the emotional and intellectual capacity to execute it. This should be someone you trust to adhere to your wishes.
At any age, you can spend more than you earn. The greater your reliance on spending your assets, the more important this factor becomes. For example, my mother receives a pension as a former teacher, as well as Social Security based on my late father’s income record. She pays cash rather than using credit cards to ensure she lives within her means. However, what if she had no pension and was relying on withdrawals form her bank and investment accounts instead? What system would she use to help ensure she wouldn’t run out of money?
The field of retirement income planning is a relatively new one. If she had been forced to spend down her bank and investment accounts, it is doubtful she’d have any money left.
If this list of risks caused your heart to beat faster, rest assured that there are ways to plan to address these risks. In most cases, we can be our own worst risk. Studies show that one of the benefits of working with an advisor is that there’s an outside perspective to help us identify and address behaviors that could put us at risk. One of my friends puts it best, an advisor can offer a calming voice of reason.
Do you have a customized retirement income plan that addresses the highlighted retirement risks? If not, contact us to discuss.