We all know that life is full of risks and we typically do our best to mitigate those risks - we wear seat belts when driving, we have insurance for our homes, and we try to eat healthy food and exercise regularly to protect our health. But what are you doing to actively mitigate your financial risk as you age and prepare for retirement? The following are ten of the biggest risks to account for when planning for retirement:
It's impossible to know how long you, or your spouse, may live. This makes it even more important to plan for an adequate stream of income for as long as you may need it. According to the Social Security Commission, the average life expectancy is age 84.3 for men, and age 86.6 for women. 1 in 4 will live past age 90, and 1 in 10 will live past 95. Be sure to understand what might happen financially if one spouse dies unexpectedly, affecting the income potential (such as from Social Security) for the surviving spouse.
Inflation reduces the purchasing power of income as goods and services increase in price. Before retirement, inflation is often offset by an increasing salary. But when you stop working, your savings need to be able to offset increasing costs in order to maintain your desired standard of living. A 3% annual inflation rate can cause expenses to double during the course of retirement (roughly, in 24 years). Health care costs are of particular concern as they have been increasing at a rate almost double that of overall inflation.
3. Withdrawal Strategy From Savings
For most households, even with Social Security income, it will be necessary to take withdrawals from savings during retirement to help pay expenses. The more that is withdrawn, the less there is to generate additional income. Taking less investment risk as you age, generating lower returns as you take withdrawals, also adds to the risk that you may outlive your savings. Don't forget that withdrawals from tax-deferred savings are taxable, lowering the spendable amount of each withdrawal. Be aware of the effect that necessary withdrawals will have on the ability of your savings to last as long as you need them to.
4. Health Care
One of the benefits of being employed is that most employers help to pay for health insurance. Once you retire, you will shoulder that responsibility on your own. Medicare, starting at age 65, can help, but it isn't free and won't cover all of the services that you may be used to (dental, vision, prescriptions, etc.). You will have the option to pay for increased coverage, with costs varying significantly from state to state and plan to plan, but even then some costs will need to be paid out of pocket. Chronic or acute illness will likely cause a significant increase in costs and unexpected out-of-pocket expenses. Health care costs for a couple can easily cost $250,000 to $300,000 during the course of retirement, making this a substantial risk to retirement savings if not fully accounted for.
5. Long Term Care
This is a separate consideration from other Health Care costs. A variety of chronic diseases, such as Alzheimer’s, can make it difficult to maintain your independence. If this happens it may require custodial and medical care in your home, or moving into a facility that can provide daily medical care.
• 70% of all people age 65 and older will need some type of long-term care.
• The average length of time that long-term care is needed is 2.2 years for men, and 3.7 years for women.
• The average cost for a one year stay in a semi-private nursing home room is $85,750.
• Less than 10% of those aged 65 have long-term care insurance.
In terms of cost, the best time to purchase long term care insurance is in your 50's, with costs increasing significantly after that. Be sure to add this cost to your expenses.
Unexpected expenses are unavoidable. Having sufficient liquidity allows you to pay for regular cash flow needs as well as some unexpected expenses (e.g. repair a roof, replace a hot water heater, significant car repairs, etc.) without needing to sell investments. Sufficient liquidity is especially important during a market downturn to avoid selling investments when prices are low, or having to sell at a loss. It is advisable to plan on maintaining at least two years of expenses (income less expenses) in highly liquid accounts, replacing any used funds only when it is an opportune time to sell investments.
7. Sequence Of Returns
Annual investment returns will vary, but returns in the 5 to 10 years directly before and after retirement are the most critical. This is typically when your investment balance is at its peak, and how you take withdrawals at this point, combined with the status of the financial markets (in a downturn?), needs to be planned carefully. Selling investments during a bear market, or any downturn, makes it much less likely that you will be able to generate the income you need/expect going forward. To help manage this risk, plan a variance in investment returns, not a constant rate for all years. Be sure to include a few negative return years, as that would not be unusual over a longer time period. The market doesn't rise year after year at a constant rate, and your investments are not likely to match the overall market's return year by year, if at all. This is especially true if you decrease risk as you age. Planning on a lower investment rate than expected, especially right at the beginning of retirement, is advised.
8. Forced Retirement
Unfortunately, many people do not get to choose precisely when they will retire. There is always the possibility that a job will end prematurely due to a company reorganization, health concerns, or even the need to care for a spouse or family member. According to a Prudential study:
• 51% retire earlier than planned
• 46% retired due to health concerns
• 30% retired due to a job loss, or early retirement offer
• 23% retired to take on care-giving responsibilities
While it's not pleasant to think about, be as prepared as possible for retirement to occur earlier than expected.
9. Government Policy/Taxes
Tax laws and tax rates can change at any time, and different income levels can be affected in different ways. Taxes themselves may be a constant, but how ordinary income, capital gains, and even Social Security income is taxed is a moving target. Be prepared for the possibility that at least some income taxes will rise over time.
The question of Social Security benefits is also an unknown. While it is most unlikely that benefits will ever end, there is a chance that they may be reduced in the future to keep the program solvent. For those already receiving benefits there may be little to no change, but there is some likelihood that benefits could be reduced for those who have not claimed yet and/or who are younger than a certain age. Hope for the best, but plan for the worst.
10. When To Claim Social Security
Choosing the best age to claim Social Security, especially for married couples, is not always straightforward. How will you decide? Will it be based on desire, a random age, or claiming as early/late as possible? Did you factor in the long term affect on your total financial plan of claiming at different ages, your family history of longevity, which spouse should claim first to maximize benefits, or the possible death of a spouse at an earlier than expected age? Did you know that it may be more beneficial to delay claiming and use other funds to pay expenses for a few years rather than claiming early just so that you don't need to dip into savings? Everyone's needs and circumstances are unique, so it's important to model all of your options to find the best solution - it will make a big difference in the long run.