The most careful plans and preparation for retirement can fall apart due to any number of things: an unexpected death, lengthy illness, a stock market crash or a pension plan that goes bankrupt. In addition, it is not unusual for people to live more than 30 years in retirement, due to increased incentives to quit early and rising life expectancies – which, in itself, presents a major risk that retirees will outlive their savings.
The longer the time spent in retirement, the harder it becomes to be certain about the adequacy of your assets. In planning for retirement – or living it – you must understand the risks that lie ahead and how they could undermine your financial security.
Types of Post-Retirement Risks
The Society of Actuaries (SOA) in the United States has identified a number of post-retirement risks that can affect income. They're grouped into four categories. People preparing for retirement or already in retirement should consider them carefully:
- Personal and family – Changes in your life or the life of a loved one.
- Healthcare and housing – These include the risk that failing health will require professional caregivers or moving to a facility.
- Financial – These risks revolve around inflation, investments and stock market activities.
- Public policy – Government can make decisions that could affect retirees.
“There are many unexpected demands for a retiree's funds. For that exact reason every one needs a realistic emergency fund. If a retiree needs to take large amounts of tax-deferred money early in retirement, it may result in future dollars being spent today. It not only decreases the amount of lifestyle money available; the money is gone, along with the potential to earn a return (compounding effect) that was to assist the retiree in the future. Spending dollars today takes away the future growth of that money, which may have been critical to maintaining a certain lifestyle or not outliving your money,” says Peter J. Creedon, CFP®, ChFC, CLU, chief executive officer, Crystal Brook Advisors, New York, N.Y.
Personal and Family Risks
Many retirees plan to supplement their income by working either part-time or full-time during retirement. In fact, some organizations prefer to hire older workers because of their stability and life experience. However, success in the job market may also depend on technical skills that retirees cannot easily gain or maintain. Employment prospects among retirees will vary greatly because of demands for different skills and may change with health, family or economic conditions.
Choosing the point at which you want to retire is integral to retirement planning. Retiring later is an alternative to increasing saving, but there is no certainty that appropriate employment will remain available. Working part-time is an alternative to full-time employment, and part-time jobs may be easier to obtain. (Read more about working past retirement age in Stretch Your Savings by Working into Your 70s.)
“Not having employment at any point can reduce your retirement income from Social Security as well as if you have a pension from your employer. It may also take longer to collect your pension if there is a stipulation regarding years of service,” says Allan Katz, CFP®, president, Comprehensive Wealth Management Group, LLC, Staten Island, N.Y.
Running out of money before they die is one of the primary concerns of most retirees. Longevity risk is an even larger concern today as life expectancies have risen. The life expectancy at retirement is just an average age, with about half of retirees living longer and a few living past age 100. Planning for only enough income to live to your supposed life expectancy will be, happily, adequate for about half of retirees. But the downside of living longer is increased exposure to other risks that are listed below.
Those who are managing their own retirement funds over a lifetime have to perform a difficult balancing act. Being cautious and spending too little might needlessly restrict your lifestyle – especially in early retirement when you are the healthiest and most mobile – but spending too much increases the danger of running out of money.
A pension or annuity can mitigate some of the risk because it provides an income stream for life. However, there are some disadvantages, including loss of control of assets, loss of ability to leave money to heirs and cost. Although it's unwise for people annuitize all their assets, annuities should be considered in retirement planning. (For more information on how annuities can provide steady income in retirement, read Inflation-Protected Annuities: Part of a Solid Financial Plan and Personal Pensions: Repackaging the Annuity.) But also carefully investigate any company where you'd place an annuity, be cautious of fees and consider other options, such as laddering bonds. There are also interest rates to consider when buying an annuity (see below).
Death of a Spouse
The grief over a spouse’s death or terminal illness contributes to high rates of depression and suicide among the elderly. Then there's the financial impact: A spouse’s death can lead to a reduction in pension benefits or bring additional financial burdens, including lingering medical bills and debts. Also, the surviving spouse may not be able or willing to manage the finances if they were usually handled by the deceased.
Financial vehicles are available to protect the income and needs of survivors after the death of a partner or spouse, such as life insurance, survivors' pensions and long-term care insurance. Estate planning is also an important aspect of providing for survivors (se Top 7 Estate Planning Mistakes.)
Change in Marital Status
Divorce or the separation of a cohabiting couple can create major financial problems for both parties. It can affect benefit entitlement under public and private retirement plans, as well as individuals’ disposable income. (For more information, read Divorcing? The Right Way to Split Retirement Plans.)
Splitting the marital assets will almost certainly lead to an overall loss in standard of living for both parties, especially if their lifestyle had been maintained by pooling income and resources. Some experts believe that an individual may need about 60% to 75% of a cohabiting couple's income to maintain his or her standard of living. This is because some expenses, like rent and utilities, remain the same, regardless of the number of people living in a household.
Although divorce rates among older couples are far lower than for younger couples, it is not uncommon for a retirement-age couple to get a divorce. Prenuptial agreements may be used to define each party’s right to property prior to marriage. (Read more about prenuptial agreements in Marriage, Divorce and the Dotted Line. Or maybe a postnuptial agreement is for you – read Create a Pain-Free Postnuptial Agreement to find out.)
Unforeseen Needs of Family Members
Many retirees find themselves helping other family members, including parents, children, grandchildren and siblings. A change in the health, employment or marital status of any of them could require greater personal or financial support from the retiree for that individual. Examples of financial assistance include paying healthcare costs for an elderly parent, paying higher-education fees for children or providing short-term financial assistance to adult children in the event of unemployment, divorce or other financial adversities.
“Bailing your adult kids out of their repeated financial mistakes can derail your retirement. For some people it’s like taking an unexpected cruise every year with all of the expense and none of the fun. It’s important to set boundaries on excessive gifts or emergency checks when you leave your steady paycheck behind. Or, if you think this may be an issue, tell your financial advisor about it so you can work those expenses into your retirement income plan,” says Kristi Sullivan, CFP® of Sullivan Financial Planning, LLC in Denver.
Retirement planning should recognize the possibility of providing financial support for family members in the future, even if this does not seem likely at or before retirement.
Healthcare and Housing Risks
Unexpected Medical Bills
These are a major concern for many retirees. Prescription drugs are a major issue, especially for the chronically ill. Older people usually have greater healthcare needs and may need frequent treatment for a number of different health-related issues. Medicare is the primary source of coverage for healthcare services for many retirees. Private health insurance is also available, but it can be costly. (Read Getting Through the Medicare Part D Maze and 20 Ways to Save on Medical Bills for tips on managing prescriptions and other healthcare costs.)
The Society of Actuaries (SOA) says that healthcare costs can be mitigated to some extent by committing to a healthy lifestyle that includes eating right, exercising on a regular basis and using preventive care. In addition, long-term care insurance can pay for the cost of caring for disabled seniors.
Change in Housing Needs
Retirees may need to change from living on their own to other forms of housing, such as assisted living, or independent living in a retirement community, which combines some assistance with housing. These residences can be quite costly, and the most appropriate form of housing for an individual in a given situation may not be available in the chosen geographic area or may have a long wait for entrance.
The likelihood of requiring day-to-day assistance or care rises substantially with age. When this will need to happen is often hard to predict because it depends on one’s physical and mental capabilities, which themselves change with age. Changes can occur suddenly, due to an illness or accident, or gradually, perhaps as a result of a chronic disease. (Read more about your options in Long-Term Care: More Than Just a Nursing Home.)
Lack of Available Facilities or Caregivers
Facilities or caregivers are sometimes not available for acute or long-term care, even for individuals who can pay for it. Couples may be unable to live together when one of them needs a higher level of care. For people who have lived together for decades, this can result not only in increased costs, but in emotional stress.
In general, little advice is available from the state or the financial-services industry on planning for long-term care costs. This may lead consumers to make uninformed decisions or to defer them and hope for the best.
Inflation should be an ongoing concern for anyone living on a fixed income. Even low rates of inflation can seriously erode the well-being of retirees who live for many years. A period of unexpectedly high inflation can be devastating.
According to the SOA, retirees and would-be retirees should consider investing in equities, a home and other assets, such as Treasury inflation-protected securities (TIPS) and annuity products with a cost-of-living adjustment feature. These types of products can be a big help in Curbing the Effects of Inflation.offset inflation. In addition, would-be retirees can choose to continue working – even if it is only on a part-time basis.
Interest Rate Risk
Lower interest rates reduce retirement income by lowering growth rates for savings accounts and assets. As a result, individuals may need to save more in order to accumulate adequate retirement funds. Annuities yield less income when long-term interest rates at the time of purchase are low. Low real interest rates will also cause purchasing power to erode more quickly.
“In today’s interest rate environment, an annuitant is locking in a payout based on today’s interest rates. The interest rate used for calculating your payout will be in the 2% range. The question to ask is, ‘Are you really willing to lock in that low an interest rate for the rest of your life?’” says William DeShurko, chief investment officer, Fund Trader Pro, LLC, Centerville, Ohio.
Lower interest rates can reduce retirement income and can be particularly risky when people are depending on drawdown from savings to finance their retirement. On the other hand, a problem also exists if interest rates rise, as the market value of bonds drops.
“With interest rates so low, retirees need to understand the impact higher inflation and rates will have on their bond investments. Bond prices move inversely to interest rates. For example, if a bond has a duration of seven years and rates jump 1% higher, they could see the value of their bond fall by about 7%,” says Dan Timotic, CFA, managing principal of T2 Asset Management in Oakbrook Terrace, Ill.
Increases in interest rates can also negatively impact the stock market and the housing market, thereby affecting the retiree's disposable income. As such, high real interest rates, over and above rates of inflation, make retirement more affordable. (See Why do interest rates tend to have an inverse relationship with bond prices? for related reading.)
Stock Market Risk
Stock market losses can seriously reduce retirement savings. Common stocks have substantially outperformed other investments over time, and thus are usually recommended for retirees as part of a balanced asset allocation strategy. However, the rate of return that you earn from your stock portfolio can be significantly lower than the long-term trends. Stock market losses can seriously reduce one's retirement savings if the market value of your portfolio falls.
The sequence of good and poor stock market returns can also impact your retirement savings amount, regardless of long-term rates of return. A retiree who experiences poor market returns in the first couple of years in retirement, for example, will have a different outcome than a retiree who experiences good market returns in the first couple of years of retirement, even though the long-term rates of return might be similar. Early losses can mean less income during retirement. Later losses can have a less-negative impact, as an individual may have a much shorter period over which the assets need to last.
Loss of pension plan funds can occur if the employer that sponsors the pension plan goes bankrupt or the insurer that is providing annuities becomes insolvent.
Defined-contribution plan accounts are not guaranteed, and plan participants bear losses directly. However, unlike pension plans, the balances in these accounts usually do not depend on the financial security of the employer, except for the employer's ability to make matching contributions and in cases where plan balances include company stock.
Public Policy Risk
Government policies affect many aspects of our lives, including the financial position of retirees. These policies often change over time along with government policy. Policy risks include possible increases in taxes or reductions in entitlement benefits from Medicare or Social Security.
Retirement planning should not be based on the assumption that government policy will remain unchanged forever. It is also important to know your rights and to be aware of your entitlements to state and local authority benefits.
The Bottom Line
Even the best-laid retirement plans can fail as a result of unexpected events. Although some risks can be minimized through careful planning, many potential risks are completely out of our control. However, understanding what the potential post-retirement risks are and considering them in the retirement planning stage can help to ensure they are mitigated and properly managed.
The main thing: Don't use uncertainty about the future as an excuse to do nothing. “The number one risk is the lack of a plan for the course of retirement," says Kimberly J. Howard, CFP®, founder of KJH Financial Services, Newton, Mass. Things may not go according to plan; you can't foresee every bump in the road. But "without a plan, the journey will not have a chance to be what you envision” at all.