The latest issue of Money Magazine had an interesting interview with a retirement expert from York University named Moshe Milevsky. In it, he detailed the three biggest risks of retirement. Any guesses as to what they are? Here’s his view:
- Longevity risk
- Inflation risk
- Market risk
What follows is a quick breakdown of each one…
Longevity risk
Longevity risk refers to the possibility that you’ll outlive your savings. With retirement lasting anywhere from 10-40 years (perhaps longer depending on how early you retire) this is a very real issue for many retirees, especially now that most people are relying on their 401(k) and IRA funds instead of a monthly pension check. Fear that retirees will outlive their savings is one of the reasons that so-called longevity insurance (which is really just a re-packaged, deferred annuity) has become increasingly popular.
Inflation risk
Inflation isn’t so much a risk as an inevitability. When you’re working, your income typically increases to keep pace with inflation. But after retirement, many individuals are living on a more or less fixed income, and inflation becomes a major factor. Consider this… Over a 25 year span, 4% annual inflation will devalue a $1, 000 monthly pension to the equivalent of just $375. Even if you’re not on a fixed income, you still have to manage your money in such a way as to minimize market risk (below) while staving off inflation risk.
Market risk
When you’re working, down markets aren’t necessarily a big deal. You’re still smack dab in the middle of the accumulation phase and, as long as you buy and hold, you have plenty of time to recover. In fact, as long as things eventually recover, down markets can boost your returns, as you’ll be buying shares on the cheap. That being said, a down market can wreak havoc if it occurs early in your retirement. The reason for this is that, once you hit retirement, you’ll likely start selling assets to generate cash. And when you pull money out during a down market, you effectively lock in that loss making it hard to recover.
Reducing your risks
As with anything, it appears that the key to defusing these risks is to diversify. According to Milevsky, this might include not just an age-appropriate mix of stocks and bonds, but also fixed and variable annuities. Traditional mutual fund investments help protect against inflation risk, whereas fixed annuities protect against longevity risk, and variable annuities promise some of the gains of the overall market while guaranteeing a minimum payout in the face of a bear market.
Note: Just to clarify the last bit about risk reduction… When asked about the fact that his own previous research that showed variable annuities to be overpriced, Milevsky responded:
If today’s variable annuities looked like the product of the same name 10 years ago, I’d still be opposed to them. They used to promise to make up losses only if you died while the market was down. But the new ones deliver benefits while you’re still alive. And the protection that they provide against market losses would be very expensive if you tried to buy it in any other way — say, in the options market. So I used to be something of a crusader against variable annuities, but now I fall back on what the economist John Maynard Keynes said when someone challenged him for supposedly flip-flopping. “When the facts change, ” he said, “I change my mind. What do you do, sir?”
I had an 401k I was fully vested in when I left that employer. I transfer it to an 401k with an annuity before the market dumped. It saved my bacon. My 108k went to 60 but with the annuity I earned 5% on my 108k and it still grows as longs as I leave it alone, the original money is protected. At 49 yr old I plan on doing just that. My husband is not an annuity fan but decided to guide me towards it. We are so glad.
It would be funny if it weren’t so sad but I could probabaly ask 10 people that I know the question – “what are the risks you face in retirement” and I would say about 1 of them would be able to say what they were.
The more I read about retirement the more scared I get. I think a lot of people got caught out in the property boom as they assumed that their home and maybe a rental property or two would fund their retirement. Choosing the best investment vehicle for your retirement funds is tricky so diversifying is the only way to go.
What you say about a down market when you are in the retirement accumulation period not being a big deal may sound good in theory . . . but it still scares the c___ out of you! Thankfully we are not actually trying to live off of a retirement account yet, but my brother in law is and the last few months have not been pretty.
I have decided that this is a good time to switch our ‘new money’ allocations in our funds to some of the stocks that have taken a big hit .. as long as they are not tied into the credit markets, there are some good values out there…
These risks can really take a wind out of your sails when you do your best to build a retirement plan that you want to be successful. The simple truth is we don’t know what the future markets will do, how long we will live or how inflation we chew at our savings. There have been many who survived the depression or the holocaust or countless other fates to eventually rise above. Life comes down to the journey, not the destination. Money is just a tool to get there.
Do what you can to make it happen through smart investing. If the world or the markets change, you can always say “no regrets.”
I’m no advisor or financial planner, but I do work inthe industry. There are two additional risks that often come up over the course of my day:
1. What about health care risk? This is a huge wild card – longevity takes on a whole new perspective if you or a spouse is in poor health and need assisted-living or nursing home care for 5-10 years (or longer). I’ve known couples to get divorced in their 70’s and 80’s so as to protect estate values for the healthier spouse (not a strategy I condone or recommend).
2. Also, consider withdrawal rate risk. If you’ve done everything right and saved, but you withdrawal too much (or at the wrong time – enter market risk), there’s a good chance you’ll run out of money.
As you say, annuities may be part of the answer, however, but inflation-adjustment is an annuity rider that will decrease your monthly annuity payment. Joint survivorship has the same effect.
When I ran the numbers for VA vs. expected market returns for a target date fund, the market won, hands down.
Pre-retirees should consult with a financial professional to create a customized solution based on their unique financial situation.
Lynda: Thanks for your comment. I’ve added a bit more info to clarify Milevsky’s point of view. I’m not saying I necessarily agree with him, but he’s an academic researcher specializing in risk, not a salesman, so his view should be relatively unbiased.
This sounded like an annuity salesman! Careful, annuities are very expensve .The name change is because we older investers know to run when we hear the word annuity unless it is a retirement fund held by our jobs.
Tnese are correct risks of retirement ;however,this is why you switch to conservative investments at retirement and pre reitrement time . Even though our government is doing whacky things on occassion including right now/ I’ll bet on inflation indexed goivernment bonds(I bionds) and inflation indexed treasuries knowing they are wealth preservers ,not wealth builders.
Thanks for your normally very helpful info. on this blog !!
I am no expert,but I had to comment….may need to be corrected/ open mind!