Most retirement planning involves devising an investment strategy to generate enough income for day-to-day costs while ensuring you have enough extra savings for unforeseen ones.
This is all tied together by an overarching goal: Having your cash outlast you.
Yet retirement planning entails so much more because retirees face a myriad of challenges that put their financial wellness at risk.
The following are a few of the more notable risks, along with some solutions to help mitigate them.
Longevity risk:
This risk tops the list for retirees. But many misguidedly seek to reduce investment risk, fearing they will lose money in the markets, leading to running out of money. This strategy can be the wrong approach, though, because if too much of capital is allocated to low-yielding investments like GICs, it may not generate enough of a return over what could be a 40-years period to keep ahead of inflation. What’s more, longevity risk also can entail higher living costs related to health care. Individuals can face paying tens of thousands of dollars annually out of pocket, for example, for private home care services, which are likely to be even more costly 20 years from now. Solutions are at hand, including for individuals without defined benefit pension plans, which provide guaranteed income for life. In lieu of these pension plans, individuals can get guaranteed income for life, or for at least a set period, from annuities.
Inflation risk:
Inflation is fresh on everyone’s mind coming out of the pandemic. Yet inflation is an evergreen risk for retirees. Even individuals with defined pension plans can see their guaranteed income eroded by inflation. The best strategy is to build a resilient investment portfolio that still has exposure to growth assets—i.e. stocks. Of course, the challenge is finding the right amount of stock holdings in the portfolio to provide returns to outpace inflation while minimizing volatility.
Market risk:
The stock market’s volatility can be a stomach-churning ride. When markets are falling, fearful investors—especially retirees anxious about running out of money—tend to make bad decisions like selling investments at the bottom of the market. Yet resilient investment portfolios can mute volatility and mitigate bad investment decisions. There are portfolios that balance growth to fight inflation long-term with income for the near-term, but balanced portfolios are more than a 50-50 split of stocks and bonds. Increasingly, portfolios include alternatives, including private investments, that are less correlated to stocks and bonds, thereby reducing volatility. These portfolios are not static. As retirees age, their portfolio typically must reduce stock market exposure while increasing allocations to bonds and other low-volatility investments.
Sequence of returns risk:
Investing in stocks may help keep ahead of inflation, but timing matters when it comes to allocating money to equities. Notably, investing large sums at the top of the market puts that capital at risk of a market crash, and the recovery could take years, harming the overall ability of a retiree’s portfolio to support income needs. Dollar-cost-averaging—buying stocks regularly in smaller amounts—can help smooth volatility. Sequence of return risk typically affects individuals accumulating wealth for retirement rather than retirees. Still, people do not want to enter retirement, forced to sell stocks at a loss to generate income they need to live. To avoid this, retirees or those nearing retirement should have a cash pool to cover two to five years of expenses that is regularly replenished by bond and dividend income, and strategic selling of profitable stocks.
Health care risks:
Universal health care only goes so far for aging retirees often facing out-of-pocket costs for medications, medical equipment, assisted living and enhanced home care. Additional health insurance—like Blue Cross—can address some costs. Another option is long-term care coverage helping with expenses for 24-hour care for diseases like Alzheimer’s. Yet, coverage is limited and often expensive, and requires advice to weigh its high costs against its benefits.
Unforeseen cost shocks:
Most retirement plans address day-to-day living costs, from property taxes to groceries and travel plans. The best plans, however, also ensure retirees have a pool of savings for emergencies and other large, irregular expenses, from vehicle and home repairs to financially supporting adult children.
Diversification risk:
Striking a balance between stocks and bonds in the portfolio can be tricky. Retirees need enough growth to keep ahead of inflation and enough low-risk investments to generate predictable cash flow. But they also want the portfolio to be diversified across both asset classes. For example, fixed income should include a variety of durations (short-, medium- and long-term), geographies and a mix of government and corporate bonds. The equity portion should also be globally diversified across different industries. Diversification shouldn’t stop there with stocks and bonds either. The portfolio can also include different alternative assets from real estate and infrastructure to gold and absolute return funds. Diversification can even extend to allocating capital to a whole life insurance policy. Annual premiums are costly, but whole-life policies provide a tax-free benefit, offering tax efficiency for the estate of high-net-worth individuals. Furthermore, whole life insurance policies can also serve as a pool of capital to draw upon later in life for additional income needs, like cost of care.
Bad advice risk:
Few retirees are experts at retirement planning, putting them at risk of making bad decisions if they go it alone. Missteps can be catastrophic for a retirement plan’s success. That’s why most are best served getting advice from trusted professionals—financial planners and money managers–who can build integrated, comprehensive plans that are resilient and able to evolve with changing markets and lifestyles over what can be a 40-year span.
