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April 21, 2013

Facing the risks of retirement

For most Americans, their working years are their saving years. The investment goal for this period is straightforward: save aggressively and invest sensibly to accumulate a nest egg for retirement.

Once retired, however, most investors shift from accumulating assets to spending them. The goal for the portfolio then becomes converting the nest egg into a predictable “retirement paycheck” that will supplement Social Security and other sources of income to support a comfortable lifestyle without the fear of running out of money.

To accomplish this requires an investment mix that strikes a careful balance between generating sufficient current income and growing the portfolio to support future spending needs. Every investor faces risks to their finances regardless of their stage in life.

However, those who are dependent upon their investments to support themselves may confront challenges that those who are still working and earning do not. They are the risks associated with spending more and receiving less in retirement than anticipated. Let’s look at them in greater detail.

Longevity risk is the possibility of outliving your savings. Americans are living longer and more active lives. This means more years that the portfolio will have to fund. Counting on living only to an average life expectancy is risky. A retirement plan should incorporate the possibility of living longer and being more physically and socially active than expected.

Inflation risk is the prospect of rising prices for goods and services (as measured by the Consumer Price Index or CPI) that erodes the purchasing power of consumers. Even at a modest inflation rate of 3 percent per year, in just 15 years, it will require $80,000 to fund the equivalent of a $50,000 lifestyle today.

Inflation affects everyone but hits those who rely on a fixed income and savings especially hard and in several ways. First, retirees spend a larger portion of their budget on items such as medical care and leisure that have historically outpaced overall inflation. Second, the after-inflation investment earnings upon which retirees are disproportionately dependent are reduced because of their diminished purchasing power. Third, inflation has a corrosive effect on traditional retiree income streams such as employer pensions and income annuities. Again, at a 3 percent inflation rate, the purchasing power of a $30,000 annual pension or annuity will be cut in half in a little over 20 years.

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