If you’re like most people, you don’t think about risks that could affect your current income, much less retirement plan risks. While having an emergency fund available for things like job loss is highly recommended, few of us have such a fund. We rely on unemployment income should we find ourselves without a paycheck. Many are unaware that if they become disabled, there are some Social Security benefits that would kick in.
However, neither unemployment insurance or Social Security will completely make up for your lost wages for the rest of your life. Given that lack of familiarity with current income risks, it’s unlikely that you would be up to speed with retirement risks prior to retirement.
While no means exhaustive, some key retirement risks are illustrated below.
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. As of this writing, my mother was a smoker into her 30s, who is now 89 years old! Hopefully those risks will favor you as well, but that’s not something one can plan.
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, will cost $1000 in the future. While one may see travel expenses as frivolous and discretionary, the cost of bread and milk rises as well. 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.
Investing retirement risk a.k.a. market risk
Investing retirement risk is the risk that the money you leave invested in investment markets will have a lower rate of return than you hoped. That return may even be negative. If you are also withdrawing from that money, bouncing back is more difficult than when you are working.
For example, a 20% decrease in your portfolio requires a 25% gain to recover back to even. So $100,000 dips down to $80,000, which requires you to earn a return of 25% on the $80,000 (a $20,000 gain) to get back to $100,000.
However, let’s see what would happen if you spent 4%, or $4000, from that $100,000 at the beginning of the year. Your balance would now be $96,000. The 20% loss would take your balance to $76,800, requiring a 30.2% rate of return to get back to $100,000. If the market was flat and you took another $4000 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 89 years, the highest marginal income tax rate has been 90%. However, she never made enough money to have to pay that rate. The highest marginal income tax rate today stands at 37%. Suffice it to say, we don’t know what income tax rates will be in the future. It’s easy to see that the amount of money you have that is subject to tax, will affect your ability to maintain your savings. You will either have to withdraw more money to maintain your lifestyle or compromise your lifestyle to maintain your funds.
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 to make and spend money not be overly complicated. If the plan is complicated, it will be important to find someone with the emotional and intellectual capacity to execute it.
At any age, you can spend more than your income. 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 deceased father’s earning record. She pays cash rather than using credit cards to ensure she lives within her means. However, what if she had no pension and had to spend down her bank and investment accounts? What system would she use to help her not 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, as she looks at the real possibility of turning 90 years old, with minimal cognitive decline, in her own home, that she would have any money left.
The retirement risk of panicking
Reading this may have caused your heart to beat faster or given way to depressing thoughts. That was not my intention! Please know that there are ways to plan to address these risks. In most cases, we can be our own worst risk. Studies by Vanguard and Morningstar highlight that one of the benefits of working with an advisor is someone 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 you are one of the few who does, would it be valuable to get a second opinion? We look forward to getting the conversation started.