Saturday, June 25, 2011

Retirement is a Risky Business

Funding a retirement that could last for decades is a very risky undertaking, not quite like Pilgrims planning to leave England to spend the rest of their lives in the unknown America, but not totally unlike that, either. They had to plan to provide for themselves for a very long time, they were heavily dependent upon themselves and their families, the risks were substantial, and turning back was extremely difficult if not impossible.

There are risks that we can’t foresee.  We didn't know until the 1980's, for example, that we need to protect ourselves against HIV and we didn't know until recently that some of the largest financial services companies in the U.S. could fail.

There are also risks we know about, like the risk of inflation, which we can prepare for. It's difficult to plan for unforeseeable risks, but there are things we can do to protect ourselves against the risks we can envision.  

Many households who had saved enough money to retire comfortably or were on track to do so saw those dreams vaporized by the stock market crash of 2007-2008.  Many others, people who thought they were quite wealthy, learned that Bernie Madoff had absconded with their dreams. As these people can tell you, hanging onto your retirement savings by carefully planning to mitigate risk is as important as saving enough money in the first place.

Inflation Risk

Imagine you retired in 1980 with a company pension (they were more common then) that had no cost of living adjustment (also common). Those monthly checks that seemed so generous in the days of Ronald Reagan have been battered by inflation. Each dollar of those pension checks that purchased $1 worth of goods back then buys only 38 cents worth of goods in 2010.

Careful planning to mitigate inflation risk can help you avoid a similar predicament at the end of your retirement thirty years from now. Inflation-protected Treasury bonds (TIPs), stocks, Social Security benefits and some fixed annuities offer inflation protection.

Longevity Risk

Financial planners call the risk that you will live a long life and outlive your savings “longevity risk”. A 60-year old man today has a 20% probability of reaching age 95 and a 60-year old woman has a 30% chance. However, there is a 40% chance that at least one member of a married couple of the same age will live until 95. That's a lot of years to fund if you’re lucky enough to live a long life.

We can ensure against longevity risk by assuming in our retirement plan that we will live to age 95. That means spending less of our savings each year in case we do live that long. Fixed annuities are insurance policies that protect against longevity risk, since they promise to pay a certain annual income no matter how long we live. Social Security benefits are an annuity with inflation protection that helps address longevity risk.

Foreclosure Risk

Owning our home at any stage of life entails the risk that we might not be able to keep our mortgage payments current. Ultimately, the mortgagor will foreclose and take our home. Foreclosure can be both more likely and more devastating after we retire because without a job we are less capable of recovering from an economic crisis.

Buying a smaller home after we retire can reduce the size of our mortgage and make foreclosure less likely.  We can also protect ourselves from foreclosure risk by renting instead of owning and eliminating the mortgage altogether.   Paying off most or the entire mortgage before we retire reduces foreclosure risk and often increases our standard of living. 

Retiree Fraud Risk

Retirees have long been the targets of fraud.  Many have lost their entire savings to shysters and Bernie Madoff recently showed that the wealthy and "financially sophisticated" are not immune. In fact, they are more attractive targets.

The best way to protect against retirement fraud is to educate yourself.  A good way to start is by reading Ken Fisher's book, How to Smell a Rat: The Five Signs of Financial Fraud.

Accumulation Risk

There is a risk that we won't save and invest enough money while we are working to fund retirement without accepting a lower standard of living than we enjoyed during our working lives.

An economic technique called "consumption smoothing" helps calculate the amount we should save before retirement to avoid a decline in our standard of living after retirement begins.

“Countdown” Risk

As we approach retirement, the risk increases that we won’t have time to recover from a market setback.

John was 63 years old in 2005 and had accumulated $500,000 dollars in his 401K account.  His son, Jacob, was 40 and had saved $150,000 in his retirement savings accounts. Both had all of their retirement funds invested in stocks.  That was perhaps an OK strategy for Jacob; for John, not so much.

John looked forward to retiring at age 65 with $25,000 a year in social security benefits and another $25,0001 to spend annually from his stock earnings. He and his wife figured $50,000 a year would support the retirement they wanted.

By 2008, the market crash had destroyed nearly half the value of both portfolios.  Jacob had 25 more years of earning and investment returns to rebuild his savings before he retired, but John did not.

John knew that he would still receive the same social security benefits and realized he had dodged a bullet when recent attempts to privatize social security had failed— the last thing he needed was to have his social security benefits invested in the market, too. But, his stock portfolio was now valued at only $250,000 and would only support $12,500 of annual spending. He would either have to reduce his standard of living after retiring or work several more years to replace the $250,000 he lost in the market crash.

The most effective way to reduce market risk is to own more bonds and less stock. At about age 55, we should reduce our exposure to stocks. By that age, we should have saved most of the money we will need to retire and the focus then changes from making lots of money in the stock market to keeping what we have already accumulated.  

Early Retirement Market Risk

The first decade of retirement is another time we should reduce our exposure to stocks. At that point, we may still have more than two decades of retirement to fund and we can ill afford to lose our savings. The aforementioned pre-retirees who lost half their savings in the 2007-2008 market crash had to delay retirement by several years, but retirees who had left the workplace after 2000 found themselves in even worse shape. Having left their jobs already, they faced an even more difficult task of recovering financially.

Health Care Cost Risk

Perhaps the biggest risk we face in retirement is the cost of health care.  Health care costs are growing at a rate much higher than the general rate of inflation.

According to a recent study by Anthony Webb and Natalia Zhivan at the Center for Retirement Research at Boston College, long term care is by far the greatest portion of health care cost risk that we face.

According to the study, at age 65, a typical married couple free of chronic disease can expect to spend nearly $200,000 on remaining lifetime health care costs excluding nursing home care. There is a 5% probability that these costs will exceed $300,000.

The prospect of needing nursing home care worsens an already bad situation dramatically. Including nursing home care, the average cost of remaining lifetime health care costs at age 65 increases from $200,000 to $260,000, with a 5% probability of costs exceeding $570,000.

According to Webb and Zhivan, less than 15 percent of households approaching retirement have accumulated that much in total financial assets.  In other words, health care costs after age 65 could conceivably consume more than most households have saved to pay for their entire retirement.

Clearly, the greatest risk to retirement security regarding health care costs is nursing home care. Medicare benefits do not pay for most nursing home care costs. Long Term Care insurance is available but it is expensive and its cost-effectiveness for many families is debatable.  

Social Security Risk

Social Security has been under attack by fiscal conservatives since its inception in the 1940’s. Though they constantly argue it is about to "go broke", moderate changes like a two-year increase in the retirement age would leave these entitlements solvent for 75 more years.  So far, these attacks have been successfully repelled. Nonetheless, it would be unwise to overlook the risk that benefits might be reduced or delayed in the future.

These are some of the major foreseeable risks to successfully funding a retirement that could last three decades or more.  After retiring, we no longer have work income to help recover from financial setbacks and the longer we are retired, the more difficult it becomes to reenter the workforce.

You might not save enough for retirement, then again you might save more than you should.  If the stock market turns against you in the last decade of employment or the first decade of retirement, your plans for the Golden Years could be toast.  Social security benefits could be reduced, you'll be a fraud target, inflation will eat away at your purchasing power.  You or your spouse might need long term care that could cost more than you saved for all of retirement in the first place. If the risks don't scare the hell out of you, then you don’t properly understand the situation. 

On the other hand, nearly all of these risks can be mitigated or even eliminated if we plan retirement properly.  Avoiding these financial setbacks is as important as saving enough money for retirement in the first place.

1 About 5% of $500,000 savings.

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