• Nicholas Pihl

The biggest risk you'll face in retirement

Updated: Sep 2

The biggest financial risk is running out of money in retirement. Are there other risks? Yes. But are they more important than making sure you don't outlive your money? Generally, no. Fortunately, there's a lot that you and your advisor can do to minimize the likelihood and severity of these threats so that you can enjoy a long and happy retirement.

Risk Factor #1: Overspending. The most essential part of a financial plan is helping clients determine how much they can afford to withdraw from their investments in retirement. Taking too much income early in retirement can jeopardize the long term health and stability of a financial plan. Conversely, spending too little may mean missing out on important goals and experiences. It's important to get the right balance.

Risk Factor #2: Sequence of returns risk. The first 10 years of your retirement are the most important to get right from a financial planning and investment standpoint. This is because you are at the beginning of a (hopefully) long and healthy retirement. Long time horizons, coupled with compound interest, mean that small mistakes today translate into big shortfalls in the future. The biggest, and most common mistake you can make as an investor and retiree is to sell stocks during a market decline. That might sound obvious, but often, people don't sell at the bottom because they want to. They sell because they need money for their living expenses and don't have any other choice. To avoid this scenario, the most important thing is to avoid taking too much investment risk so that you can hold your stocks through to recovery, while living off less depressed assets such as cash and bonds in the meantime. Ideally, you'd even rebalance your portfolio so that you're actually buying stocks in a downturn, rather than selling them.

Risk Factor #3: Bad investment behavior. Now, I know that I just said that people sell stocks during downturns because they need the money. But it's also often the case that people sell for more emotional reasons. After watching their life's savings dwindle day by day, week by week, they sell not because they think it's a good idea, but because they can't take any more pain. Their anguish overrides their better judgment. When an advisor helps you avoid this mistake, they rescue your retirement.

The other "bad behavior" is taking too much risk. Many investors get swept up in "hot trends" that have less to do with investment merit, and more to do with FOMO (Fear of Missing Out). By the time such investments become widely known and popular, however, they are usually high risk, low reward. Not exactly the stuff to build your retirement around. By keeping your money out of such ventures, you preserve it for what really matters, a long and comfortable retirement.

Risk Factor #4: Losing to inflation. Until recently, we've been blessed with 30 years of low and declining inflation. Even this relatively benign inflation, however, becomes a serious problem when left to grow throughout a 30 year retirement. Historically, this has led to a 50% loss of purchasing power. At the end of your retirement, each dollar only buys half of what it did at the beginning. Imagine if, starting tomorrow, you had to live on half of your current monthly budget. Does that align with the life you want for yourself? Probably not. It is vital, then, that your retirement income provides you with the same inflation-adjusted income in year 30 that it did in year 1. The good news here is that the long term returns of the stock market have beaten inflation by roughly 5% per year. By allocating the long-term bucket of your portfolio to stocks, you mitigate much of the risk of inflation. But be careful not to fall afoul of Risk Factors #2 and #3, which result from too much stock exposure. Again, it's about balance. A big part of what a financial planner does is determine the right balance for you and your portfolio.

Risk Factor #5: Overpaying taxes. Taxes will likely be your biggest expense in retirement. Unfortunately, for every extra dollar of unnecessary taxes you pay, you don't get more value from the IRS. In fact, you'll likely get even less value as higher taxable income may trigger higher Medicare premiums. Luckily, there are several ways to make sure that you aren't paying more in taxes than you have to. You want to minimize unneeded income as well as make sure that the income you do receive is as tax efficient as possible.

Without getting too far into the weeds, tax brackets are like a series of buckets you fill up with income. The lowest brackets fill up first, before filling up the higher brackets. Once you're bumping up against those higher brackets, you might take any additional income from a tax-free Roth account. Likewise, if you have low income in a certain year, you might take extra money out of your pre-tax IRA (either as a distribution or Roth Conversion) to fill up the lower buckets. This means you volunteer to pay taxes at lower rates today, rather than higher rates tomorrow. The details can get complicated, so this is another area where it is worth talking to a financial planner.

Risk Factor #6: Healthcare Costs. Healthcare costs are the other major expense in retirement. There are two pieces to this. One is the rising cost of staying healthy and active. You'll not only need more healthcare as you get older, but the care you do get will be more and more expensive over time (healthcare costs have grown at roughly twice the rate of overall inflation). The other big expense is Long Term Care. If you're like 2/3 of women, and 1/2 of men, you'll need help taking care of yourself towards the end of your life. Declining strength and loss of balance might cause you to lose the ability to live autonomously. Worse still, you may experience cognitive decline towards the end of your life. Even if you're in good shape physically, you may lack the mental wherewithal to take care of yourself. The best way to prepare for these costs is to build them into your financial plan. Assume that you'll have high and rising costs of healthcare, and that you may need to pay for 2-3 years of care in a nursing home or assisted living facility.

Risk Factor #7: Inadequate insurance. If you're like most retirees, you've worked hard throughout your entire adult life to create your current financial situation. Accordingly, you want to make sure that if something bad were to happen, it wouldn't cripple your financial future. Consider a tree falling on your house, someone getting hurt on your property, or being liable for medical expenses from a car accident. These things happen in an instant. If you have adequate coverage, these are unpleasant, but passing events. If, however, you are personally liable for the resulting expenses and don't have enough insurance, you could lose a significant chunk of the nest egg that you had counted on for your retirement. That either means cutting back on your expenses or increasing the risk of outliving your money.

Risk Factor #8: Suboptimal Social Security timing. Many people think that they have to file for Social Security as soon as they retire. But that's not true. Moreover, this misconception can cost them tens of thousands of dollars over their lifetime. It's not the same answer for everyone, and there are many things that can affect it. One rule of thumb, is that if it is likely that you'll live past age 85, you might be better off waiting to take Social Security. This is because Social Security pays out a higher monthly benefit the longer you wait to claim it. Of course, it also depends what the rest of your financial situation looks like and if you can fund the gap between where you are today and the age at which you'll start taking Social Security. It all depends on your exact situation, and you're better off talking it through with an advisor than trying to guess at what's best for you.

To summarize, the biggest risk for retirees is the risk of running out of money in retirement. I've outlined a few of the biggest factors to consider, as well as some of the ways an advisor can help you mitigate these threats. Since this is a summary article, I haven't gone into much detail on the specifics of each risk-factor, so don't take this as financial advice. Especially you Do-It-Yourselfers.

Lastly, just because running out of money is the biggest financial risk, it doesn't mean that other financial considerations aren't also important. Nor does it mean that other, non-financial risks are any less relevant. You want to make sure you have a solid estate plan, for instance, so that your assets go to whom you want, when you want. This is especially important if you have kids and got remarried at any point in your life. Another component of estate planning is drafting instructions for long term medical care, like designating who will have medical power of attorney, and which life-saving measures you want caregivers to take. There's a lot that you'll want to get right, not just for financial security, but also for quality of life.

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