You spend a lifetime working hard, and saving as much as you can for when you no longer can or want to work a.k.a. retirement). The last thing you want is to get to that point, only to have something devastate your retirement fund just as you're about to start drawing it down. Here are the top 7 risks, and what you can do to minimize them.
This is an abbreviated version of "7 biggest risks to your retirement plan and what you should do about them" (if you're a glutton for punishment, or just like digging deeply into important topics, feel free to check it out).
Many people want to just know the bottom line, so here’s the abridged version, with just what you need to know to safeguard your retirement plan from the 7 biggest risks that could derail and devastate it.
1. Market Risk
Stock markets go up, and stock markets go down. Here’s what you should do to minimize the risk that a bear market demolishes your portfolio just as you start retirement.
First, invest as much as you can during your working life. My recommendation is to start as high as you can (which could be as low as 1% of income if need be) and then divert to savings more than half of each raise, bonus, or significant cash gift or bequest you get. This will let you enjoy life more in the present, but will also help maximize your future self’s portfolio value at retirement.
When you near retirement, shift more of your investments from equities to bonds and cash-like assets. One rule of thumb is to subtract your age from 120 and use the result to determine the fraction of your portfolio that should be in stocks, equity mutual funds and ETFs. Alternatively, consider gradually moving out of equities starting about 5 years before your planned retirement date. Then, once you retire, move gradually back into equities. How far out of equities and how far back should be determined with the help of a financial advisor, or you could cut equities down to near zero (say 20%) by your retirement, and use the “120-age” rule to determine how far back into equities you should return.
2. Sequence-of-Returns Risk
The same mitigations of market risk will also mitigate the risk that a bear market strikes exactly at the wrong time. In addition, have 1-2 years’ worth of expenses in a highly liquid and low risk asset such as money market fund or high-interest savings account. Then, if the market drops, draw from your cash-like assets and/or bonds, and if it rises, draw from your equity position and/or from dividends and bond interest payments.
3. Interest-Rate Risk
To mitigate interest rate risk, which is what happens if your fixed-income investments suddenly pay much lower interest, consider buying an immediate annuity or if you’re still a few years from retirement, a single-premium deferred annuity (SPDA). Time the purchase for when interest rates are higher, to provide the best payout. Consider also investing a significant portion of your equity allocation in high-dividend stocks and funds investing in those.
4. Inflation Risk (especially healthcare inflation)
To mitigate inflation risk, which is when rising prices reduce your money’s purchasing power, invest in assets that grow faster than inflation, such as equities and Treasury Inflation-Protected Securities (TIPS).
5. Investor Behavior Risk
To mitigate your own fallibility as a human investor (i.e., one affected by the emotions of fear, greed, and over-confidence), check your own investment history to see how likely you are to sell in a panic when the market drops like a rock, and how frequently you invest in certain assets when you hear or read that they just had a huge rally. The more you tend in that direction, the lower your stock allocation should be, and the less frequently you should be looking at your portfolio. Don’t view or read any pundit market analysis, as those are usually more about sensationalism to drive clicks than about true advice about the direction markets will take in the near future.
If you want to do something other than simply buy and hold, try buying when assets drop, and rebalancing and selling some winners when they soar. A financial advisor can be very helpful in restraining yourself from your worst investor self.
6. Longevity Risk
To mitigate the risk that you outlive your money, plan to draw 3% of your portfolio in your first year in retirement to supplement any Social Security benefits, pension, annuity, or other guaranteed income. Then, in Year 2, increase your Year 1 draw by the rate of inflation in that first year, and continue adjusting for inflation each year thereafter.
Consider using some of your portfolio to buy a fixed annuity as mentioned in the mitigation plan for interest rate risk, preferably with an inflation-adjustment rider. Try paring down any non-discretionary expenses as you can, e.g., by moving to a lower-cost area for retirement, and especially if that area has lower taxes than your current location.
If you can afford it, delay claiming Social Security benefits until you’re 70, as that will provide you with permanently higher benefits – about 24% higher than if you claim at your full retirement age (FRA, which I assume is 67), and 77% higher than if you claim at age 62, the earliest possible time.
7. Health Risk
To mitigate your health risk, improve your diet, and exercise regularly (at least walking an hour a day). Maintain good health coverage, including dental coverage which isn’t provided by Medicare. Consider getting an HSA-compatible high-deductible plan, and investing the maximum allowed in it each year. Don’t touch the HSA balance until you’re in retirement, and then use it only to cover healthcare expenses. Consider buying a long-term-care insurance policy, preferably when you’re in your 50s so it’s cheaper and your health doesn’t prevent it.
The Bottom Line
Life is full of surprises, including many unpleasant ones. However, if you mitigate against the biggest risks to your retirement plan as detailed above, your retirement will likely be much smoother and more comfortable.
If you'd like to find out how financial strategy can help you along this path, email me and we'll set up a free, no-strings-attached call to figure that out.
This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.