The Five Risks of Retirement
Retirement income planning starts with understanding the 5 risks of retirement.
“Whether you are planning a future retirement or are already retired, you face increasingly complex challenges in planning for retirement income to last a lifetime.”1 When building a retirement plan, it is important to consider the Five Risks of Retirement:
- Healthcare Expense
- Asset Allocation
- Sustainable Withdraw Rate
Today’s retirees face unique challenges that people in the past may not have had to consider:
- People are living much longer. In some cases, depending on life expectancy, retirement years may even exceed working years.
- Heath care cost are rising at a rate of 7.6% a year, over double the rate of historical inflation.
- Only thirty-one percent are covered by a traditional pension, while only 28% of employers offer retiree health benefits. 2
Retirees will be responsible for a higher percentage of their income in retirement.3Source: 3 Social Security Administration, “Income of the population 55 or older, 2008,” April 2010, based on highest quartile of $55,889.
Risk One: Longevity
A retirement income plan should ensure you don’t outlive your assets in retirement. Many people may only consider their individual life expectancy, but according to statistics, half of the population will live longer than their life expectancy.
A more prudent approach to retirement income planning is to plan for longevity, which is how long you are likely to live. We always say that clients should plan on living and not dying; it is always a good idea to plan to live longer than you think you will.
Retirees should plan on living past their life expectancy
“Fact: The United Nations estimated there were 316,600 Centenarians (people living to be greater than 100) living in 2o12.”Source: Annuity 2000 Mortality Table, Society of Actuaries. Figures assume a person is in good health.
Risk Two: Health Care Expenses
Retirees today face longer lifespans, rising healthcare costs, and a decrease in employer retirement benefits post retirement. In addition the safety and financial sureness of Medicare may causes further gaps in coverage in the future.
Retirees need to plan on funding a considerable amount of there own medical costs for heath care that is not covered by Medicare.
And as we live longer, it is an absolute necessity to consider how you will fund possible long-term care, which averages over $70,000 annually in the U.S. 40% of Americans over age 65 will enter a nursing facility for some period during their lifetime.4
Estimates show that a 65-year-old couple retiring in 2010 will need approximately $250,000 to $430,000 to cover medical costs in retirement.**
Risk Three: Inflation
Inflation is the long-term tendency of money to lose purchasing power. This can have a significant effect on retirees as purchasing power of savings are gradually diminished by constant inflation. Inflation occurs due to the increase of goods and services as well as a general deflation in the value of the currency itself.
For example, today a gallon of milk costs about $3,50. Assuming 3% inflation, this same gallon of milk will cost $6.70 in year 2035. Inflation will pushes the price up for everything from milk to plane tickets. It is critical that retirement savings at least keep pace with inflation.
Even periods of low inflation can damage the purchasing power of retirement savings
From 1926 to 2009, inflation has averaged 3%. While history does not always dictate future, it is important to plan on this trend continuing. Consider the inflation chart to the left. This graph depicts the purchasing power decline of $50,000 assuming inflation rates of 2%, 3%, and 4%.Assuming hypothetical inflation rates of 2%, 3%, and 4% (historical average from 1926 to 2009 was 3%) to show the effects of inflation over time. Future inflation rates may vary from historical inflation rates.
Risk Four: Asset Allocation
People who fear losing their nest egg, sometimes invest too conservatively, while people who have not saved enough for retirement might invest too aggressively to try to fill their savings gap. Both of these have inherent risks and should be avoided.
Many people are hesitant to assume any market risk, especially after seeing retirement accounts lose significant value in the 2001 and 2008 recession. However, it is important to remember that long-term returns are attributed to time in the market, not timing the market.
For most retirees, a balanced approach to asset allocation is the best option. Below is a graph showing how four portfolios of varying degrees of risk have historically faired against inflation and health care costs. Remember, equity investments generally involve greater risk than other investments, including the possibility of losing principal. Asset allocation does not ensure a profit or a guarantee against losses.
Examples of target asset mixes designed to meet goals
Risk Five: Excess Withdrawal
Even the healthiest retirement savings accounts can be exhausted if retirees do not maintain a sustainable withdraw rate. As a retiree exits their income earning years and transitions into retirement income years, it is imperative that they do not outlive the money later. Many times this is one of the greatest fears of retirees, and rightly so.
The first step of retirement income planning is to assume that you will need 70% of your preretirement income in retirement. However, this very based on every individuals expectations. In a recent study, nearly 60% of pre-retirees though they would be spending less once they retired. However, this same survey found that fewer than 25% of retirees were spending much less than they were before retiring– with 50% spending the same or more. 5
Conventional wisdom is if you do not want to outlive your retirement nest egg, the sustainable with draw rate is 4%-5%. This means for every $1,000,000 in retirement savings, you can generate between $40,000 and $50,000 in annual income.
Sustainable withdraw rates can extend the life of a portfolio. See how a 65-year-old couple retiring in 1972 with $500,000 is affected.