By Dr. James M. Dahle, WCI Founder
Retirement is risky. I mean, life is risky, but the financial risks you face once you are no longer generating earned income are no joke. You need to understand what they are, quantify them in a reasonable way, and have a plan to deal with each of them.
The 7 Retirement Risks
Let's go through each of them one by one.
#1 Longevity Risk
Longevity risk is the risk that you run out of money before you run out of time. Normally, you would think having a long, fruitful life would be a good thing. That's probably true, as long as you don't run out of money. Truth be told, almost nobody really ever runs out of money completely. Most have a backstop from Social Security, and any logical person will cut back spending as they see their nest egg dwindle. The real risk is having to cut back your lifestyle dramatically in retirement.
That happens all the time, even if the classic image of having to eat Alpo is not particularly accurate. At least one study suggests that people actually overestimate this risk. Only 58% of 65-year-olds expected to live until 80, yet 66% of them actually do. Among the financially literate, I find just the opposite. People with some wealth are often terrified they'll outlive their money. Thus, it is helpful to see one of my favorite charts, often called Rich, Broke, or Dead. I use it to encourage people to spend a little more.
The chart comes from engaging-data.com. Using reasonable assumptions, black represents the chances of being dead at a given age, and red represents the chances of being broke. The various shades of green represent not being broke—the darker the green shows increasing levels of wealth. The point is that with a typical safe withdrawal rate, you are far more likely to end up wealthy than broke early in your retirement. And later in retirement, you're far more likely to be dead than broke.
How to Beat Longevity Risk
No, the answer isn't euthanasia. The answer is to have a realistic estimate of this risk. The first number you need to understand is the true risk of you living a long time. What is your life expectancy, according to the tables? While it is good to know the average, it is more important to know the range. Let me introduce the Actuaries Longevity Illustrator. You simply put in a little bit of information like this:
Hit “view results” and it spits out this:
Katie and I have already survived into our mid-40s, and we're relatively healthy. This estimator says our life expectancy is in the upper 80s to lower 90s. But it isn't a magic crystal ball. There's a range there, and if you take the 10th percentile and the 90th percentile, that suggests that I have an 80% chance of dying somewhere between 73 and 101. That's 28 years. That's a huge range. If you add these numbers together, there's a halfway decent chance one of us will live to be 100. If we retire at 60, we probably really do need our money to last 40 years.
How do you beat longevity risk? There are two good ways. The first is to have so much money compared to what you're spending that there is very little chance of running out of money. This is the approach we are taking simply because we have enough money to do so. The approach often looks like just spending the income from investments, or using a ridiculously low withdrawal rate—like, 1,2, or even 3%.
The second approach is to guarantee you won't run out of money. It turns out that if you ask people how much wealth they would be willing to give up to guarantee that they won't run out of money, the answer is 27%. What does it actually cost to buy that guarantee? Well, it depends. But my point is that the guarantee can be purchased. You do so by taking pensions offered by employers, delaying when you take Social Security, and purchasing Single Premium Immediate Annuities. Yes, the guarantees are only as good as the guarantor (employer, US government, and insurance companies), but it's worth something.
More information here:
#2 Investment Risks in Retirement
If longevity risk is the risk of you living too long, investment risk is the risk of your money not living long enough. Poor investment performance, especially in the early years of retirement (often called sequence of returns risk), can really do a hatchet job on your nest egg. Bad performance combined with regular withdrawals can decimate a nest egg surprisingly quickly.
How to Beat Investment Risk
There are a lot of investment risks that can be eliminated simply by being a good investor. You can eliminate single stock risk by not investing in individual stocks. You can beat manager risk by not investing in actively managed funds. Use low-cost, broadly diversified index funds as the base of your stock, bond, and perhaps even real estate portfolio. Avoid extreme portfolios, market timing, and stock picking. You need to make sure you're taking on enough market risk to reach your goals, but not so much that you panic-sell in a market downturn. Your own behavior often matters more than the behavior of your investments. You cannot completely eliminate market risk, but you can certainly minimize it by investing intelligently.
#3 Inflation Risk
Inflation risk is the risk that the value of your money decreases due to a general increase in the cost of the goods and services that you purchase. Even moderate levels of inflation can decimate a cash-heavy nest egg over long periods of time. For example, with 5% inflation, $10,000 turns into the equivalent of $3,584 over 20 years.
How to Beat Inflation Risk
You generally beat inflation risk by taking on market risk.
“But I don't want to invest in stocks; they're risky!”
Sure, they're volatile over the short run. But over the long run, investments in riskier assets—such as stocks and real estate—are much more likely to keep up with inflation than investments in less volatile assets, such as savings accounts, CDs, money market funds, and bonds. Leveraged real estate, in particular, is a great inflation hedge. The value of the property rises with inflation, and rents can be raised. The cost of the loan is also decreased by high inflation.
Inflation-indexed bonds, such as TIPS and I Bonds, can also help beat inflation. Alternative assets—such as cryptoassets, collectibles, precious metals, and commodities—may also potentially play a small role.
More information here:
#4 Health Risk
Health risk is the risk that your healthcare ends up costing more than you think. Studies suggest people dramatically underestimate the cost of their end-of-life healthcare. A particularly expensive medical problem or an extended long-term care stay can decimate even a medium-sized nest egg. However, these costs can be offset by the fact that sick people can't spend a lot on other stuff (like travel), and illness generally puts downward pressure on longevity.
How to Beat Health Risk
There is a significant element of luck here, but there are steps that can be taken. These include eating well and exercising regularly. Maintaining good mental health practices goes a long way, too. Preventive vaccines and screening tests can also help. On the financial side, you should have a plan to maintain health insurance throughout retirement, realizing that Medicare is neither free nor all-inclusive. You may also need to pay for Medicare Part B and D or a Medigap policy. Early retirees need a solid plan for health insurance. If married, you also need to either have a long-term care policy or enough assets to self-insure without leaving the other spouse impoverished. A large HSA can also be very useful during retirement as it can use tax-free dollars to pay for Medicare premiums, long-term care, and just about any other healthcare expense.
More information here:
#5 Family Risk
Family risk is a broad term that includes the personal and financial aspects of divorce; illness or death of a spouse; and adult children becoming ill, divorced, or needing to move back home or other financial support. An example is the fact that after your spouse dies, you end up having to work with the higher single tax brackets than the lower Married Filing Jointly tax brackets. Another example is the sandwich generation, which finds itself caring for elderly parents and 30-year-old kids playing video games in the basement at the same time they move into retirement. This might require maintaining a larger house, with the accompanying property taxes and other costs.
How to Beat Family Risk
This is another one where bad luck can play a major role. I've said many times that date night is the best asset protection. Doing all you can to build and maintain that marital relationship is obviously wise. Maintaining the health of you and your family members through healthy lifestyles and good preventive practices is also a good idea. Beyond that, it usually comes down to having enough extra to help those you care about without impairing your ability to care for yourself. Roth conversions can help offset the cost of one spouse dying early in retirement and pushing the long-living spouse into higher brackets.
#6 Policy Risk
Policy risk is the risk that the government does something that imperils your retirement. This might include changing the rules on Social Security, raising tax rates, taxing Roth IRA withdrawals, or nationalizing private assets Cyprus-style. This might also be a good place to include the risk of devastation, as discussed by William Bernstein. You know, like when someone drops an atomic bomb on your town.
How to Beat Policy Risk
Barring a functional crystal ball, the only solutions are diversification of assets and income sources and having plenty of extra. This risk is likely much smaller than most of the risks discussed above. Having some money overseas, in other currencies, or even in cryptoassets might help. Having tax diversification between tax-free, tax-deferred, and taxable accounts may help. Taking Social Security early might even help. As far as dealing with devastation, there are few really good solutions there other than diversifying assets geographically and building bomb shelters. This might be another good place for crypto. But the fact remains that the likelihood of a major devastation of your nation is probably higher than a lot of the risks that retirees spend a lot more time worrying about. The average empire lasts 250 years. Depending on when you start counting, America is somewhere between 104 and 246 years into its empire.
#7 Scam Risk
Scam risk is the risk that someone takes advantage of you and steals your money. This becomes increasingly common as you age and your mental acuity drops. It might be a family member, a formerly trusted advisor, or just some cold caller or “Nigerian Prince.”
How to Beat Scam Risk
Everyone should have a plan in place to manage their own senility. Even if you don't need a financial advisor at 70, that doesn't mean you won't need one at 80 or your spouse won't need one at 90 after you're gone. If you don't have a professional fiduciary on your side, gradually bringing in trusted and knowledgeable family members has some real value. Of course, the more you bring in, the more potential there is for those trusted people to take advantage of you, too. Quite a Catch-22 there. It also helps to become familiar with common senior scams so you are less likely to fall for them.
What do you think? What do you see as the major risks facing retirees, and what are you planning to do about them? If you had to rank these seven risks, what order would you put them in? Comment below!