A large part of a financial advisor’s job is to make you aware of risks and how you can protect yourself from these risks.
Health and disability insurance are prime examples. A loss of income presents a serious risk to your financial stability; carrying the appropriate types of insurance insulates your from these risks.
As you enter retirement, you face a new set of risks. You’ll want to be aware of these retirement risks and the measures you can take to reduce their effects.
1. Sequence Risk
Sequence risk has to do with the how investment returns are achieved. A portfolio may average a 6-7% annualized rate of return over a decade’s worth of time, but how that average is achieved can vary depending on which decade it is. In one decade you may have a few years of positive returns followed by several years of negative returns. In a different decade the opposite may occur. You can have two identical portfolios with the same average return, the same amount of withdrawals and the same level of volatility, but if the negative returns occur in the beginning of retirement, it will have a compounding effect and if you don’t reduce your withdrawals, your money will run out far faster than it would if the positive returns had occurred at the beginning of retirement. It is this order in which returns occur that is sequence risk.
What to do: How can you protect yourself from sequence risk? Setting aside an appropriate amount in safe investments that can be used during years with negative portfolio returns can help mitigate the effects of sequence risk.
2. Withdrawal Rate Risk
No matter how good your investment returns are, if you withdraw too much money too fast, your portfolio will not be able to recoup. I call this overspending risk. When you are working, you have time to pay off debt that accumulates from overspending. In retirement, this is more difficult. If you overspend, and withdraw too much from your investments, you are jeopardizing your future income.
What to do: You can monitor withdrawal rate risk by tracking your withdrawal rate; each year divide your total portfolio withdrawals into the account balance. A withdrawal rate in excess of 5% is cause for concern, although an appropriate withdrawal rate can vary depending on your age and investment style.
Learn more: 6 Withdrawal Rate Rules to Follow in Retirement
3. Inflation Risk
During working years, raises tend to offset the effect of inflation. In fact, income often grows much faster than inflation during your most productive working years. In retirement, you have to provide your own raise by investing in a way that will provide enough growth to keep pace with inflation, or by starting with enough capital that you can withdraw more as needed due to rising costs.
What to do: Your Social Security income will be one of the few sources of income that will automatically increase with inflation, and careful thought should be put into when you begin benefits. Delaying the start date of your Social Security benefits is like buying an inflation adjusted annuity and is one of the most effective ways of offsetting the effects of inflation risk.
4. Longevity Risk
The biggest retirement risk is that you are planning for an unknown length of time. Will you need income for fifteen years, or for thirty-five? The longer the time horizon, the greater the effect of other retirement risks such as sequence risk, and inflation risk.
What to do: Social Security and immediate annuities can be sources of guaranteed income that can help protect you against longevity risk; which is the risk of outliving your money. A few insurance companies also offer longevity insurance, a form of an annuity where you set aside a lump sum at about age 60, and it provides guaranteed income beginning at your age 85.
Learn more: Longevity Insurance and How to Use It
Wade Pfau, Director of Curriculum Development for the Retirement Management Analyst (RMA) Designation Program, discusses the retirement risks listed above and more in his Retirement Researcher Blog Risks in Retirement.