Rampant retirement risk
Heading into retirement can raise a slew of scary questions. Will unexpected expenses throw off your retirement plan? Could a market crash decimate your carefully built nest egg? Most important, do you have enough money to last you through your golden years?
Taking a closer look at the risks of retirement can allay some of those fears. After all, financial service professionals spend their days studying the many retirement risks you face and finding clever ways to hedge against them.
“Far too many people focus on the main principal risk and the fear of losing money,” says Casey Mervine, a Schwab financial consultant. “There are other risks that can be managed.”
Learn how to protect yourself against seven of the biggest retirement risks you’ll face.
Retirement risk No. 1: longevity
Back in 1935, when Social Security was first established, the average life expectancy was only about 61 years. That number has been rising ever since, to 78 currently, according to Stephen Horan, head of private wealth management for the CFA Institute and co-author of “The New Wealth Management.” Moreover, once you’ve already made it to age 65, you’re likely to live until 81 or 83 years old.
A healthy diet, exercise and a history of long-lived ancestors can boost your life expectancy still higher. So even if you think you’re going to live until age 85, you need to plan for the possibility you’ll make it to age 95 or 100, Horan says.
“Overwhelmingly, the biggest one is the risk of outliving your money,” says Ken Fisher, chief executive officer of Fisher Investments.”Most people underestimate the amount of time they’re going to live, and they invest as if they’re going to die in 10 years.”
Retirement risk No. 2: inflation
Another key risk is inflation, the inevitable increase in the cost of goods and services, including housing, clothing, food, electronic devices and health care. Even with very low rates of inflation, say 3 percent a year, you would lose half of your purchasing power over two decades, Mervine says.”That’s probably the biggest risk to investors’ long-term ability to make ends meet,” he says.
To guard against inflation, you can invest in inflation-protected securities or other investments that will gain value as overall prices climb. For instance, stocks in your portfolio aimed at growth rather than income will provide a hedge against inflation, says Michael Reese, Certified Financial Planner and founder of Centennial Wealth Advisory based in Traverse City, Mich.
Retirement risk No. 3: the market
When you hear the word risk, the danger that usually springs to mind is market risk. That’s the scenario in which you’ve amassed a healthy portfolio of stocks and bonds only to see it plummet in value because of a market crash or other disruption to the global financial system.
The solution: Diversify your portfolio among a healthy mix of stocks, bonds, commodities and real estate, with no outsized holdings in one company’s stock. On the stock side, a portfolio would be allocated among several asset classes, geographic regions and companies of various sizes. It should reflect a combination of value, growth and dividend-paying investments. On the fixed-income side, it would be invested mostly in government and investment-grade corporate bonds with varying terms and durations.
“Diversification is one of those free lunches,” Mervine says. “The more diverse a portfolio, the better.”
Retirement risk No. 4: reinvestment
Don’t overlook the possibility that your investments will mature at an inconvenient time. It’s not unusual for a bond to be called earlier than you expect, at a time when interest rates are too low to replace that investment with a similarly profitable one, Mervine says.
The cure: a healthy variety of maturity dates. “You need to think about not having all your investments coming due at the same time,” he says. “Every year you’ll have something coming due that can be repositioned into the longer-term interest rates.”
Retirement risk No. 5: sequence of returns
When you regularly invest in a retirement plan during your career — a practice called dollar-cost averaging — you purchase fewer shares when the market is up and more shares when the market is down. You’re effectively buying low and curbing your purchases when prices are high.
Unfortunately, when you withdraw money from your portfolio during retirement, the volatility of markets can inflict substantial damage. If you take a set amount in distributions each month, you end up selling more shares when the market is low — locking in your losses rather than giving the market a chance to recover. “I liken it to the reverse of dollar-cost averaging,” Horan says.
To protect against this risk, he recommends setting aside two years’ worth of living expenses as a buffer. When the market is down, you can draw down from that cash rather than selling from your portfolio. When it’s up, you can sell your investments at a profit.
You can also purchase annuities and other guaranteed-return investments to cover your bare-bones living expenses, Reese says.
“Now the sequence of returns is only happening to your excess funds, and you can pick and choose when you want to pull those excess funds,” he says.
Retirement risk No. 6: fraud
You’re in control of your faculties and capable of making investments now. But what might happen in the next 20 years? There’s the risk of cognitive decline, which would make it harder for you to make sound financial decisions. Similarly, there’s a risk you may fall prey to a swindler, which could happen regardless of your mental state.
“One big risk is trusting the wrong people — or not trusting anyone,” Mervine says.
To combat this, educate yourself now. Make sure you understand how the financial professionals in your life are paid and what incentives they might have to sell you products or ensure good results. Line up your trusted advisers now, while you’re most able.
“You want to know how the incentives work, for you or against you,” he says.
Retirement risk No. 7: taxes
In retirement, a good adviser can help you withdraw money from investments with minimal damage to your overall portfolio. That person should also pay attention to the tax implications of purchases and sales to avoid a big tax bill.
“If you’re not responsible about how and why you trade,” says Mervine, “it can really limit your returns. Everything you pay out in taxes over time can be very dramatic: tens of thousands, if not hundreds of thousands, in a lifetime.”
Then, of course, there’s the risk of changes to the tax brackets or the tax code generally. “We are aggressively converting from IRAs to Roth IRAs because that would immunize our clients against tax risk, which I think is going to be substantial,” Reese says.