There’s no hiding that the road to retirement is both long and risky. Many Americans live paycheck to paycheck, making prudent saving effectively impossible. According to the Corporation for Enterprise Development, nearly 17 million households in the United States, 14.7 percent of the total, fall below the income poverty threshold. Moreover, 25.4 percent of Americans fall below the liquid asset poverty threshold, meaning they don’t possess enough wealth to last three months at the poverty rate without new income.
These Americans are the hardest off, but even those in the lower-middle and middle income brackets have had difficulty successfully executing a retirement plan. According to the CFED report, one quarter of “middle class” Americans are liquid-asset poor. Excluding the value of a primary home and any defined benefit plans, 57 percent of households say they have less than $25,000 in savings and investments, while 28 percent say they have less than $1,000. Furthermore, the Center for Retirement Research at Boston College has warned that 53 percent of American households are at risk of not having saved enough to maintain their living standards in retirement.
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But even besides the general risk of not having saved enough, there are many specific risks that can derail even a diligent planner. Dave Littell, director of the Retirement Income Program at The American College, and his colleagues study these risks and educate financial advisors on how to develop strategies to defend against them. Here are a couple of those major retirement risks.
1. Longevity risk
Believe it or not, sometimes living too long can be a problem. Imagine this: You are a male who retires at the age of 66. Knowing that your life expectancy is about 82 years, you create a retirement plan that will last you until age 90. To most people, an eight-year buffer may seem adequate.
Here’s the problem. According to the Social Security Commission, nearly one in four people still alive at age 65 are expected to live past age 90. Moreover, one in ten are expected to live past age 95. These are odds that can’t be ignored. The chance that you may live well past average life expectancy — especially if you are healthy heading into retirement — must be a factor in your planning. The last thing most people want to do in their 90s is suffer through poverty.
There are any number of unavoidable risks when it comes to portfolio depletion, but one thing that people can do is simply restrain withdrawals from their retirement portfolios. According to Littell, research shows that a 4 percent or a 4.5 percent inflation-adjusted withdrawal rate will be sustainable for about thirty years. There are a couple of other time-tested ways to hedge against longevity risk, such as annuity products that provide lifetime payments.
2. Health-expense risk
One thing that most people are bad at is accurately estimating future expenses. When it comes to medical expenses in retirement, for example, most people tend to underestimate how much money they will need to cover medical expenses by anywhere between $100,000 and $310,000.
Littell explains that even with insurance, the development of medical problems usually means increased out-of-pocket expenses. This is well understood — most people expect to develop some medical problems at some point during their retirement — but its cost is difficult to estimate. Littell points out a Fidelity study which showed that on average, retired couples thought they needed just $50,000 to cover medical expenses. The reality, according to a study conducted by the Employee Benefit Research Institute, is anywhere between $151,000 and $360,000.
3. Market Risk
Market risk is a particularly dark specter hanging over the retirement portfolios of the baby boomers. Just as the oldest of this generation was gearing up for retirement, crisis ripped through the U.S. economy, demolishing the value of homes and financial assets. Equity wealth — the backbone of many retirement portfolios — fell as much as 40 percent between January and October 2008. Although markets have recovered to their post-crisis levels, the crash permanently reduced the value of retirement accounts below where they would have been otherwise, totally derailing the retirement strategies of millions of Americans.
Moreover, research conducted by Wade Pfau, a professor at The American College, showed that wealth accumulation can vary greatly over different thirty-year periods. On average, at a given savings rate, a hypothetical portfolio at retirement averaged ten times salary after thirty years. However, the range behind this average was anywhere between four and twenty-seven times salary. A portfolio that is just four times salary is unlikely to carry you through a comfortable retirement.
“One approach to address this challenge in retirement income planning is to choose a bifurcated investment strategy, with investments and products with little or no market risk chosen to meet basic needs and more market risk taken to address discretionary and unexpected expenses and legacy goals,” suggests Littell. “With this approach, basic expenses can be met with Treasury or other low risk government bonds, buying annuity income, or even deferring Social Security benefits.”
4. Forced Retirement Risk
The financial crisis did more than destroy equity wealth; it destroyed millions of jobs. Headline unemployment peaked at 10 percent in October 2010. Many people working part time to help finance their retirement and those still working full-time but nearing retirement lost their jobs and have been unable to find new work during the anemic recovery.
Littell points out an EBRI study that shows that overall, 47 percent of people retire earlier than planned. Most (55 percent) do so for health reasons, while 20 percent do so because of downsizing. According to an MMI study, among the oldest Baby Boomers, 54 percent retired early, 25 percent of which did so because of the loss of a job (interestingly, only 32 percent cited health reasons).
Littell suggests that one way to approach the risk of forced retirement “is to show retirement readiness at different stages — with the goal of building resources to provide a reduced but adequate standard of living — let’s say 10 years from retirement, a more comfortable standard of living 5 years prior to retirement and the desired standard of living at the planned retirement age.”
On a side note, the MMI study found that less than 10 percent of those who were forced into retirement early had adequate resources. Although there are many specific risks that people should look out for in retirement, the greatest risk is simply not having the necessary resources. This is best achieved through diligent savings and prudent investment.
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