By FPA member Amy Jo Lauber, CFP®
Last Updated: June 28, 2010
Everyone is familiar with the concept of risk. When you discuss risk with an investment professional, it’s typically in terms of market fluctuations and your individual risk tolerance. While market risk is an important factor, there are several other risks you will likely face in retirement. You and your advisers should identify potential risks in your plan, the consequences of each risk, and develop strategies to avoid or mitigate each risk to improve your plan’s probability of success.
Longevity risk is the most notable of retirement risks; the risk of living past your life expectancy and not having sufficient resources to maintain your lifestyle. According to the U.S. Department of Health and Human Service, Center for Disease Control and Prevention, a person born in 1950 in the United States was expected to live just beyond his or her 68th birthday. Interestingly, if that same person lived to age 65, he or she is expected to live another 14.1 years, until age 79. When combined with the life expectancy of a spouse, the odds are more than 50 percent that at least one spouse will live to 90. Each year new mortality tables are created to address our increasing longevity, largely due to improved medical treatments. The best strategy to utilize when addressing longevity is to plan for it. Invest to protect as well as grow your retirement nest egg, establish and maintain appropriate withdrawals and monitor your plan regularly with your advisers. Your strategy should also address any desires you have for leaving money to your heirs.
Inflation risk represents how purchasing power is eroded over time. Retirees are especially susceptible to this type of risk because their sources of income (typically Social Security and pension, if any) are fixed (Social Security benefits are adjusted annually according to the Consumer Price Index, which is typically slightly lower than inflation). Statistics have shown that two major components of a retiree’s expenses — housing and medical care — increase at a rate higher than inflation. Retirees must remain mindful about the long-term effects of inflation, and work with their advisers to address the issue. Equities have been proven to be an effective hedge against inflation.
Income risk is closely related to market risk and is defined by unexpected reductions in income (interest and/or dividends) due to changes in the interest rate environment or the performance of the stocks in a portfolio. Asset allocation strategies that strive for total return (interest, dividends and capital growth) can help manage, but not eliminate, income fluctuations. Your plan should identify the amount of investment income that is required to maintain your standard of living and appropriate investments should be chosen to help meet that need.
Public policy risk addresses governmental or legislative changes that can affect your retirement income; most notably taxation. Discuss tax strategies with your advisers regularly and consider employing a “tax diversification” strategy with your retirement assets by using traditional tax-qualified plans [Individual Retirement Account (IRA), 401(k), and the like], Roth IRA/Roth 401(k) and taxable investment programs. Public policy risk can also affect estate and long-term care planning. It is important that you review your plan regularly with your advisers to stay abreast of changes in federal and/or state laws.
Your living expenses in retirement are partially controllable, but some expenses, such as health care, may be beyond your control. It is estimated that Americans will need more than $250,000 in retirement to cover medical care alone, above and beyond what Medicare will cover. Health care costs continue to be a force to reckon with, a factor compounded by our longer life spans. There have been advancements in consumer-driven health care programs, such as Health Savings Accounts, that may be appropriate for you. Talk to your advisers.
Related to health care costs is the risk of requiring care for a long-term need that is not medical in nature. Many Americans mistakenly believe that Medicare will pay for home care or nursing home costs only to find out too late that, in most cases, it won’t. A discussion with your advisers (including your financial planner, portfolio manager and attorney) should address this risk. If your strategy includes obtaining long-term care insurance, your planner can advise you more thoroughly what benefits to seek and how the annual premiums may affect your cash flow.
Lastly, life event risk represents changes in your life, such as the death of a spouse or a divorce, that threaten your financial security. Your plan should include a survivor needs’ analysis and address how assets are titled. All estate documents and beneficiary designations should be reviewed on a regular basis. Making pre-paid funeral arrangements can help ease the financial, as well as emotional, burden put onto your family or friends.
Retirement, like every other stage of your life, is full of risks. It is important to clarify your needs as well as your fears, and discuss them with your advisors.
FPA member Amy Jo Lauber, CFP®, is the director of financial planning for Harold C. Brown & Co., LLC.