Retirement should be a period of low stress, financial security and enjoying time with family and friends. A secure and stable retirement is obtainable through proper planning. But, there are five potential risks in retirement to avoid. These include investment risk, longevity risk, inflation risk, health care risk for unplanned expenses, and sequence risk. Each of these are explained below along with strategies to help mitigate these risks for a more successful retirement.
Investment Risk
Investment risk relates to how retirement assets are invested. A portfolio aggressively invested entirely in stocks could lead to major losses during market downturns. Similarly, an overly conservative portfolio invested entirely in U.S. government bonds, could lead to years of low returns. Lower returns often do not provide enough income during retirement.
To mitigate investment risk, have an emergency fund in cash or cash equivalents to cover four to six months of living expenses. This prevents a retiree from needing to sell assets during the worst of a market downturn. In addition, creating a retirement portfolio consisting of 60% stocks and 40% bonds provides the diversification needed to earn adequate returns while reducing volatility.
Adding in rental properties, business income or annuities provides further diversification and stability in retirement income. For more strategies on countering investment risk see Turning 50: 10 Factors to Consider and Ready to Retire? Don't Focus on Portfolio Size.
Life Expectancy or Longevity Risk
None of us knows how long we will live. Financial planners refer to actuary tables to provide estimates, but there are many factors, such as proper exercise and diet, that further longevity. Living a long time is great news, if you have the resources to support yourself in old age. If longevity runs in your family, consider waiting to take Social Security Retirement Benefits until age 70 when benefits are maximized. Also consider saving for a few extra years before you retire to increase your savings, or contemplate working part-time in retirement to reduce your reliance on retirement savings.
Also, consider reducing living expenses to be able to reinvest some of your retirement income each year. This could include downsizing to a smaller house or cutting back on expensive splurges in the first few years of retirement. For example, if Kate has $50,000 a year in retirement income, but lives on $45,000 she can keep the extra $5,000 invested adding years of additional retirement income and reducing her longevity risk.
Inflation Risk
This is potentially the biggest risk facing retirees in the coming years. The United States has benefited from low inflation, averaging about 3% per year over the last several decades. However, there are periods where inflation spikes to double digits as it did in the 1970s. Inflation eats away at the purchasing power of retirement income.
If inflation is 10% for the year, a retiree living on $50,000 this year would need $55,000 the next year for the same standard of living. Significantly more than the $51,500 needed if inflation was only 3%. A few years of high inflation is punishing to retirees on a fixed income. A $50,000 life style today would require $65,000 in income just a few years later. Retirees quickly see their purchasing power erode in a high inflation environment. For more details on inflation risk see Ready to Retire? Beware of Inflation Risk.
Retirees can successfully navigate inflation risk by having a portfolio that includes some faster appreciating growth stocks and rental properties. Over time rents can be raised to help keep pace with inflation.
Sequence Risk
Saving for retirement is only part of the equation. Drawing down assets in a sustainable and tax efficient manner is crucial for a stable retirement. Withdrawing too much from a portfolio, especially in the first few years of retirement, is a huge contributor to sequence risk. This can happen for two reasons. First, a person's retirement may coincide with a weakening stock market. If a retiree's portfolio falls from $600,000 to $500,000 and they continue taking distributions they are depleting their savings at a much faster rate. However, if they are able to live on emergency funds for the next six months they could suspend their withdrawals, giving the portfolio time to recover.
The second form of sequence risk is self imposed, when retirees take larger withdrawals than planned for to buy depreciating items like cars or boats, or to pay for weddings or major vacations. These expenses are fine if a portfolio is large and diverse enough to absorb them. If not, these withdrawals deprive the retiree of future retirement income. For example, if Sam withdraws $100,000 to buy a luxury car he loses $4,000 in future annual retirement income. This is based on a 4% withdrawal rate in retirement. To learn more about withdrawal risk see Withdrawing Funds in Retirement. He also has the added expense of insuring and maintaining the car.
Health Care Risk
According to the Fidelity Retiree Health Care Cost Estimate, an average retired couple age 65 in 2021 may need approximately $300,000 saved (after tax) to cover health care expenses in retirement. Suffering a medical event without the proper insurance can lead to health expenses that dramatically reduce a retiree's future retirement income. Proper health insurance mitigates some of this risk, but taking preventive measures such as proper exercise and diet is one of the most cost effective ways of reducing this risk.
As retirees age they will also have access to Medicare options which can help provide health care for a manageable fee. To prepare for these risks allocate a certain portion of your retirement portfolio specifically for health related expenses. Purchasing a deferred annuity, which is bought 20 or 25 years in advance of payout, can provide a substantial income stream late in retirement when health issues are more likely to emerge.
Another option to mitigate this risk is to purchase a rental property, with the expectation that it will be paid off over the next 20 years. The appreciation combined with the elimination of the mortgage will provide an asset that can specifically be tapped in the event of a health emergency.
To develop a successful retirement plan, see the book Become Loaded for Life and the 10 Stages Workbook. If you read and enjoyed the book, a positive Amazon review is appreciated and helps other readers to find it.
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