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.
While there are no guaranteed hedges against future inflation, exercising good judgment when estimating the size of the nest egg needed, determining the investment mix, and adjusting fixed income sources such as pensions to reflect their after-inflation value can go a long way to mitigating its damaging effects.
Public policy risk encompasses the potential hazards that underfunded private and public pensions, federal and state budget deficits, and unsustainable trajectories of Social Security and Medicare pose to all Americans, especially those facing retirement.
It is difficult to imagine a scenario where benefit cuts and increased taxes are not part of the solution to these large and difficult problems. This means that retirees should be prepared to pay for more of their retirement costs than previous generations.
Unexpected retirement costs risk is the threat posed by large, unplanned expenses such as those related to health care needs, special housing requirements, and providing financial assistance to family members who may have experienced a change in health, employment or marital status.
Market risk is the danger that poor investment returns, particularly in the early years of retirement, can cause permanent damage to a portfolio. The ebb and flow of the financial markets has little impact on the investor who is regularly adding to the portfolio. In fact periodic market downturns can be beneficial, because the resulting share price declines allow for the purchase of more shares that have the potential to grow over time.
However, once the investor begins taking systematic distributions, as many retirees do, the combination of poor returns and the withdrawals present a serious risk. More shares must be sold at lower prices in order to raise the funds to cover spending needs. These shares are then permanently removed from the portfolio and thus cannot benefit when the market eventually rebounds. The earlier in retirement this occurs, the greater the damage to the portfolio. Conversely, strong investment returns during the early years of retirement reduces the chance that the assets will be depleted prematurely.
Risk is unavoidable and none of us can predict the future. What we can do, however, is anticipate the likelihood and consequences of future events, take sensible steps to protect against them and then move forward and enjoy our lives. For most of us, this will likely be enough to secure a comfortable retirement.
John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.