By FPA member Scott Hughes, CFP®, MBA
Last Updated: May 16, 2011
Did you know that many public employees are starting to retire much earlier than society’s traditional age of 65? In recent years, this is becoming more common and that’s the good news! After all, who wouldn’t like to enjoy their “golden years” as early as possible?
Keep in mind that the retirement years for public employees can span a longer time period than their working careers did. These added years of retirement can present pre-retirees with a more complex set of decisions and risks to consider than a conventional retirement would.
Warren Buffet, one of our country’s wealthiest men, once said, “Risk comes from not knowing what you’re doing.” Do you know how to retire at a younger age than traditionally expected without risking the financial assets you’ve saved for your retirement? For many people, the answer is “no” — as retirement tends to be a first-time experience.
As with any new experience, doing something for the very first time, like retirement, can sometimes lead to innocent mistakes. Your first inclination might be to only make provisions for the dreams and goals you would like to fulfill once you retire. However, two things you must first do in preparation for all of the changes that will come with retirement are a careful evaluation of your financial assets and an assessment of all the risks that may lie ahead.
Whether you go this alone or work with a financial planner, carefully review of all of your financial assets (Social Security benefits, employer-sponsored retirement plan(s), pension(s), investments and savings).
Then take a reasonable assessment of the risks involved with an earlier retirement. These include:
- Longevity Risk: Have you considered what your natural life expectancy might be? Make sure that you overestimate how long you are going to live. It could be a real problem if you live to the age of 90, but when you determined your financial plan in retirement, you only planned to live to 80. No, you can’t take it with you, but you should make sure your money outlives you!
- Investment Risk: Are you emotionally prepared for the swings in the markets once you are retired? Have you considered that your retirement accounts may need to be invested in a diverse portfolio? Have a financial plan that relates to your investment strategy and consider the benefits of asset allocation and diversification. Remember, this is a retirement account that may need to last 30 to 40 years. You need to determine if you will need your retirement accounts to provide both income and growth. This is typical for most retirees. In many cases, this is a significant strategy change from when you were building your portfolio during the working years. The time may have come to transition from building the retirement account to using the account.
- Inflation Risk: How much did your first car or home cost? How much does that car or home cost today? How much will your utilities cost in the future? Will gas and food cost more and more each year? Unfortunately, the one constant in most retirees’ lives is that many normal expenses increase regularly. Be prepared to see your income needs increase regularly. Make sure your retirement income plan accounts for inflation. Typically, three percent is the minimum expectation, but many financial planners use a four percent inflation rate when making projections.
- Unplanned Expenses Risk: Have you ever had to pay a lot for something you never planned for? Perhaps an automobile broke down or a roof had to be repaired. Just because you’ve retired doesn’t mean these normal but unplanned life events cease to happen. Make sure to have a cash reservoir or emergency reserve account set aside for unplanned expenses.
- Distribution Risk: How much should you take from your savings each year to ensure it lasts your lifetime? Are you going to give yourself a raise each year from the portfolio in order to keep up with inflation? What happens to your withdrawal if the portfolio does not perform up to your expectations? Significant research has come to light on sustainable withdrawal rates in retirement. Be sure to investigate the implications of your distribution rate. Is it going to be three, four, five percent or more?
- Medical and Long-Term Care Risks: Are you able to carry your current health insurance into retirement? Do you have long-term care insurance for needs not covered by health insurance and Medicare? Is your spouse also covered on these plans? Many retirees find that more than 20 percent of their budget goes towards health care costs. Recent studies have warned that retired couples should be prepared to see their total cost at more than $250,000. This is a staggering number and one that many believe will increase faster than inflation. Make sure your retirement income plan includes an annual budget for these costs as well as a savings reserve for any years you might experience a spike in costs. Strongly consider purchasing long-term care insurance before you retire.
- Survivor Risk: Have you adequately prepared for the income needs of your spouse or loved ones if something were to happen to you? Are there enough assets? Do you have life insurance or survivorship benefits built into your pension? One of the greatest mistakes you can make is to not provide a continuation of your pension benefits to your spouse if something were to happen to you. Typically, pension plans provide an option for you to take a lesser benefit now to ensure that your spouse would also receive a lifetime of income if something were to happen to you. It can be tempting to take the maximum amount and hope for the best, but investigate these alternatives extensively before making a final election. If you decide not to take these survivor options, calculate the amount of capital your spouse would need if something were to happen to you. If you do not have adequate assets, seriously consider purchasing life insurance.
- Institutional Default Risk: Have you heard that Social Security is facing financial burdens? Have you had any fears about the safety of your pension? These are issues largely out of your control. The fact of the matter is that Social Security should be there in some meaningful form and public pension plans boast a far better track record than the often heard about failed private pension plans. However, keep up with the issues and regularly read the publications your plan provides you. If you are concerned, make sure to have a backup plan or savings set aside.
- Pension Option Risk: Are you burdened with the multitude of pension elections that you must make but cannot change once elected? If your pension offers several different pay-out options or allows for a lump sum distribution, sometimes called DROP (Deferred Retirement Option Program) or PLOP (Partial Lump Sum Option), make sure to carefully evaluate your alternatives. Project your needs in retirement and match the pension income option that matches that need and accounts for all of the factors that drive your retirement income plan.
All of these risks are very real and need to be factored into any decisions you make about your retirement assets when planning for your retirement. Mr. Buffet had it right that risk comes from not knowing what you’re doing. But there are plenty of options available to help you determine the best course of action when it comes to your retirement assets. If you need help, a professional financial planner can assist you in navigating through these risks and help you to accomplish your life goals through the proper allocation of your financial assets.
Remember, a small mistake on a small amount of money is a small problem. That same small mistake on a large amount of money is a BIG problem, so take some time to carefully prepare and review your plan. Most importantly, congratulations on a great career and enjoy your retirement!
FPA member Scott Hughes, CFP®, MBA, is a Financial Planning Advisor and President of Hughes Financial Services, LLC, in Herndon, Va. Hughes Financial Services, LLC, is a branch office of and Securities offered through WFG Investments, Inc. (WFG). Member FINRA/SIPC. Scott Hughes is a Registered Representative of WFG.