The following is not an exhaustive list by any means, but these are the main risks that you face in your decumulation years. Retirement income planning is a balancing act among these many risks, since a lot of times you make a change to reduce one risk and end up increasing the likelihood of another. This type of planning involves an open communication between the advisor and the client so the advisor knows what’s most important for the client, and the client is well educated on the trade-offs.
Longevity Risk – this is the risk of outliving your retirement financial assets. As far as planning goes, it is usually looked at as “pass/fail”; “pass” if the client dies with money left in their accounts, “fail” if they run out of funds before they die. A better way to look at it is even if the client runs out of money, how much monthly income are they left with, and at what age did they run out. A client with $8,000 per month of guaranteed lifetime income whose accounts officially hit a zero balance in their early 90’s is in a much more enviable position than someone left with $2,500 per month who runs out of funds in their 70’s.
Sequence of Returns Risk – this risk has to do with the order in which investment returns are achieved in years that a client is withdrawing from (decumulating) a portfolio. Two identical clients can start off with the same size nest egg, withdraw the same amount each year, and earn the same average rate of return over a 30-year period, but one client can run out of funds, where the other identical client can leave a significant sum to his heirs. How can this be? Well, the first several years are critical in a retirement period where you’re spending down your assets. If you combine steep and/or sustained market losses over these early years where you’re selling securities for spending needs, you end up having to sell more and more shares as the share price falls in order to meet your needs. This depletes your nest egg quicker, even to the point where large investment returns later in retirement won’t be enough to prevent running out of funds.
Market Risk – this risk has to do with the potential of depleting retirement assets due to a downturn in financial markets. The most common markets are the stock and bond markets. Most people realize the volatility inherent in the stock market, but a lot of people don’t realize that bonds and bond funds are bought and sold in a secondary market much the same way as stocks. So, rising interest rates, inflation, and corporate weakness are things that can cause potential sharp or prolonged decline in the prices of these securities.
Long-Term Care Risk – this risk has to do with the potential catastrophic ongoing expenses of needing custodial care. Custodial care can be provided if you’re a resident in a nursing home, but can also be provided on a more part-time basis in your home. Average costs for nursing home stays currently cost about $85,000 per year. Very few retirees are equipped to handle the financial burden of needing long-term care over a period of several years. And in order to get state-funded Medicaid to provide custodial care, you will need to spend down your assets to near exhaustion. Although there are some solutions to getting Medicaid without having to spend down all your money (especially for married folks), these solutions in themselves are likely to be expensive to implement.
Interest Rate Risk – this is the risk that interest rates rise during periods or over the course of your retirement. The main thing this impacts is the price of bonds. As mentioned bonds and bond funds are traded in the public market. When interest rates rise, the price of bonds and bond funds fall. The reason for this is that if interest rates rise, a potential investor can buy a new bond that yields a higher interest rate, rather than buy a similar but older bond that yields a lower interest rate. In order to give this new investor an incentive to buy the older, lower yielding bond, they have to be priced at a discount.
Inflation Risk – this is the risk that the price of goods and services goes up over time. Inflation can hit different sectors of the economy differently. Gas prices have declined sharply over the last 3 years, but the cost of health care has risen dramatically over that same period. However, overall, the cost-of-living rises over time. If the cost-of-living goes up at a modest 3% per year, the average cost of goods and services will double every 20-25 years. This gives you perspective if you are looking to plan for a retirement period of 30 years or more.
Liquidity Risk - this risk has to do with the risk of not having easy access to your money. Surrender charges in your deferred annuity can be steep, especially if it’s a new contract. And turning an annuity lump sum premium into a lifetime income stream by annuitizing it basically eliminates this lump sum from your assets and you no longer have access to its balance. CDs usually have early withdrawal penalties too if you take money out before they mature.
Asset Allocation Risk – this risk has to do with investing either too conservatively or too aggressively in retirement. If you have the vast majority of your retirement assets in stocks and funds containing stocks either shortly before or shortly after you retire, you open yourself up to the possibility of declines in the stock market decimating your portfolio. If you have the majority of your money in cash, CD’s, or even fixed annuities for an extended period of time, your investments will likely not even keep pace with inflation and you risk a financial shortfall in the later years of retirement.
Loss of Spouse Risk - this risk comes from losing a spouse, usually earlier than expected, and the sources of income tied to their life. If one spouse is receiving a significant pension that has either very little or no survivor benefits, the loss of this spouse can cause a significant income shortage after they’re gone. If both spouses have very similar Social Security income amounts, then a couple’s Social Security gets almost cut in half when the first spouse passes. Income requirements typically don’t get cut in half when one spouse dies, but typically stay at around 70% afterwards, all else being equal.
Health Care Expenses Risk – this risk has to do with the rise in the cost of health care over the retirement period. Healthcare has to do with the monthly cost of Medicare and supplemental insurance premiums, prescriptions, and out-of-pocket expenses when you use the health care system. This tends to be more of an issue moving forward as increasingly fewer and fewer employers are offering medical insurance to retirees. Also, health care expenses are expected to rise faster than Social Security annual COLAs.
Excess Withdrawal Risk – this risk tends to affect those who don’t have a holistic retirement plan. Those who haven’t created a plan with a competent financial advisor specifically trained in retirement income planning tend to have very little idea of what a safe withdrawal rate should be from their retirement portfolio. They also don’t know how to position their retirement assets to maximize the amount they can safely withdraw. Lastly, those folks basing their decisions on antiquated rules like the “4% rule” tend to increase their risk of running out of money as the 4% rule today is likely too aggressive of a withdrawal guideline.
Public Policy Risk – this risk has to do with the change in the law of policies affecting retirement financial matters. Sweeping changes to the Social Security system to address underfunding concerns may either reduce the amount of income you were expecting to receive, or even eliminate certain claiming strategies you were planning to use. Also, this risk applies to the potential increase in taxes levied against those who are drawing from Social Security, pensions, annuities, and IRAs. It can also include other changes such as the elimination of various tax advantages and deductions for retirees.