April 24, 2023 – Ryan Berning
For many, the vision of a successful retirement is having the freedom to pursue hobbies, travel and spend time with friends and family without the obligations of a full-time job. While there are many opportunities to achieve this lifestyle, there are also numerous risks that can get in the way.
So how well do retirees perceive risks when deciding what to purchase, how much to save and where to invest? According to a recent study from the Center for Retirement Research (CRR), retirees face five key risks when planning their lifestyle after their working years – and more surprisingly, they often underestimate how likely these are to occur. Let’s look at these risks and identify ways to mitigate them.
The single biggest risk retirees face is living longer than expected and using up all their resources in retirement. And what may be more surprising is that, according to the CRR study, both men and women consistently underestimate their life expectancy. Said another way, people tend to be pessimistic about their longevity on average, which means their retirement plan is likely to run into trouble as they age.
One way to address longevity risk in financial plans is to test different cash flow and age expectancy scenarios, such as with Monte Carlo modeling and long-term forecasting. By simulating your retirement and spending plans hundreds of times, financial advisors can test the probability that you will be able to fund your hypothetical needs during retirement, one simulation at a time. And by testing different life expectancy ages, advisors can help determine if a retiree’s desired spending levels can be maintained throughout retirement or if adjustments are needed.
It is common for retirees to have unexpected medical expenses and long-term care needs. Out-of-pocket expenses rise quickly with age, and health costs in retirement have increased substantially over the past few decades. But similar to longevity risk, many retirees ignore the likelihood of increased medical bills over their lifetime. In fact, the CRR study indicated that the average retiree anchors to their current medical expense and extrapolates that into the future, despite the reality that medical expenses tend to increase with age.
To address this risk, a retiree must consider additional spending needs for medical care and use appropriate inflation assumptions in their retirement planning. Failure to account for these factors could force a retiree into an uncomfortable future.
The risk associated with market downturns has grown for retirees. As traditional pension plans have become less common, many retirees no longer have this option as a steady source of income. That means retirees are not only faced with managing their nest egg but also the even harder task of withdrawing money from it. For a retiree, cash flow from their investments is the ultimate goal in retirement. And because most retirees will need to rely on some growth of their savings throughout retirement to fund their current and future cash flow needs, some level of risk will always be present.
To address the risk, retirees need to build enough protection into their portfolio to cover short-term periods of volatility while not losing sight of the long-term growth they need to battle inflation. The first step is to build an investment plan that addresses their near-term needs while balancing long-term uncertainty. Second, a retiree must then consider their withdrawal strategy from their investment accounts. And third, retirees have to prepare themselves mentally for the periods of heightened economic uncertainty and how they will respond.
This risk includes divorce, death of a spouse and adult children becoming ill or unemployed. Protecting against these unpredictable situations can be achieved through proper estate planning, insurance planning and cash flow planning. Up-to-date estate plans ensure a retiree’s wealth will be transferred as intended and in the most tax-efficient way possible at death. Additionally, life insurance planning can help address a shortfall in financial assets or estate tax issues depending on a retiree’s circumstances. Finally, the cash flow planning process can factor in the financial needs of a loved one. A financial advisor can help determine the monetary amount a retiree could provide to a family member, how long the retiree could provide support, and how doing so might affect their retirement plan.
For most retirees, Social Security is their primary income. However, the program’s trust fund reserves are projected to be depleted in 2034. Therefore, without any policy changes, everyone could experience a 20% to 25% benefit reduction after that point.
To address this risk, the first step is to determine how much of your current income Social Security will replace. If a retiree is planning for their Social Security benefit to make up a substantial portion of their retirement income, policy risk is going to be a very real concern. A retiree will need to review the many strategies to claim Social Security. Each year a retiree delays claiming Social Security, their future benefit increases. In fact, by waiting to claim after full retirement age – currently 67 for people born in 1960 or later – a retiree will receive an 8% increase each year up to age 70. In addition to thoughtful claiming strategies, the best way for a retiree to combat policy risk is to save more, delay retirement and reduce spending in retirement. Just because a retiree is eligible to start their benefit does not mean it is the best financial decision.
Overall, studies have shown that retirees find it difficult to understand their true risks in retirement and, more importantly, how to protect against them. That’s why education about these risks – and possible ways to manage them – is so important. While it can be hard to predict unforeseen events, preparation and awareness go a long way. Working with a financial advisor is one way to assess your personal situation and prepare for a successful retirement, no matter what life brings your way.
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