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When considering retirement, a financial planner must review a number of risks with the client, as well as potential methods to deal with each risk.
1. Risk of Living too long
This is a commonly feared event, as most people worry that they will outlive their savings. This is a very legitimate concern as a couple that reaches 65 years of age is likely to have at least one member who survives into their 90s! Few people realize the complexity of ensuring an income that will be secure and provide stable purchasing power for 30 to 40 years of retirement needs. This risk can be partially mitigated by using annuities, which can be structured to pay out an income over an entire lifetime, no matter how long. However, annuities are a complex investment that requires expert opinion and review before purchase.
2. Risk of Not living long enough
There are two risks here. The first is that a spouse or parent whose income is being used to support another person dies prematurely. Buying life insurance mitigates this risk. There is also the risk of having saved “too much.” There is always a tension between savings and spending to enjoy life and its nicer material things. This is usually a less pressing concern when compared to the risk of running out of money.
3: Risk of Default
The subprime crisis of 2008-2009 is a good example of why this is a concern. During that time (and after), there were defaults of various types including structured products and real estate. Even concerns about whether Social Security will “be around” to pay benefits in the long term fall under the category of default risk. Pension fund promises from an old employer (even government below the federal level) may or may not be reliable deep into the future. This risk is partially mitigated by having a carefully investigated and highly diversified collection of investments.
4. Risk of Illiquidity
Some investments are hard to sell at a fair price. Classically, real estate is a relatively illiquid investment. “Quick” sales of real estate rarely result in fair returns of value. Other illiquid type investments include long-term bonds, life insurance and annuities. This risk is mitigated by reviewing how your net worth is structured and asking yourself the questions about how quickly your investments could be turned into cash at a fair price.
5. Risk of Inflation
The loss of purchasing power over long periods of time is a major concern of income planning during retirement. If inflation is 4%, you need to spend 4% more in dollars every year to buy the same amount of “stuff.” If your investments yield 5% annually, and are taxed at 30%, your principal savings are decreasing in purchasing power annually as well. Over several decades, inflation markedly increases the first risk I listed — that you will outlive your savings. This risk can be very hard to mitigate, but a portfolio that holds some tangible assets (such as real estate, gold and commodity stocks) would be expected to help.
6. Risk of Investments
Here the risk is that your investment portfolio will fail to provide an assumed return. When planning for retirement income distributions, both the planner and client must assume a reasonable return on the different investments that are made. If the long-term investment returns fail to achieve the assumptions, then this increases the risk of outliving your savings as well. This risk can be mitigated with low-cost investing methods, a diversified approach to asset allocation and periodic review.
A current or future retiree must also consider financial aspects of which pools of savings to use (pre-tax vs. after-tax accounts) and in what order. Designing and using an investment strategy that will manage the many risks of needing an inflation-adjusted income stream over decades is a daunting task, one made harder by the rise in life expectancies over the last few decades.