ROAD TO RETIREMENT
CHAPTER 6: 4 Retirement Risks You Should Start Planning for Now
A critical component of any successful retirement is maintaining the financial independence you enjoyed during your working years, and add to that your vision of a retirement lifestyle you so long have dreamed about — whether that includes traveling the world or staying put by the lake and enjoying the grandkids. No matter your goals, the ability to collect post-retirement income from your savings, pensions, Social Security, and other assets (such as rental property) is what helps you achieve that successful retirement, however you define it.
No surprise, but life does throw curveballs to our best laid plans. Fortunately we can plan for most of the common ones now. Throughout my career, I’ve seen too many people try to navigate these hiccups with very little forethought and often once it’s too late — meaning after they retire. That’s not to say you can’t manage risks once you leave the workforce, but it could make it much more challenging without a predetermined gameplan. Instead, the best time to plan for retirement risks is before retirement, as you’ll likely have more flexibility and choices at your disposal.
Did you know that NASA had a predetermined contingency plan in place whenever they were about to launch the space shuttle into space? They thought through thousands of different ‘worst case scenarios’ our astronauts could find themselves in and corresponding corrective actions to help them get back home safely. Well, you need to do the same with your retirement, have a predetermined plan in place just in case something dire would happen.
For instance, while it may not be your first choice, you probably could work longer if you were faced with a setback, like a sagging stock market or runaway inflation. However, once you turn in your retirement papers, that option may no longer be feasible.
So, let's take a look at the four most common risks to your retirement income, and how you can best prepare to minimize their potential damaging effects.
Risk 1: Longevity
People are living longer1. No surprise there, that’s good news, but it also means your retirement income may need to last longer, too. And that need can be more substantial than you realize.
The simplest and arguably most fun way to deal with this expensive “problem” of living too long is to sell your home, move back in with your parents, eat like a college student all over again on a diet of Ramen Noodles and cheap beer. Ok, maybe that's not very realistic…but the lack of responsibility sounds fun! Fortunately, there are more practical ways to beat longevity risk.
Be prepared to go back to work. Part time at least.
I often propose this right out of the blocks when a client first asks me if I think they are ready for retirement. Most of the time I get a negative look as it sounds like I am already telling them to go back to work at the exact same moment they are asking me if they can retire! However the inquiry is posed on purpose, as I know statistically if the client is willing to temporarily supplement their retirement income with side work for those times when things are a little tight (instead of withdrawing more from the investment savings that might be temporarily under water), then I know they WILL be ready for retirement.
Delay when you start collecting Social Security.
Another way to reduce the risk of outliving your money, is to extend the collection starting date for Social Security. Remember that Social Security and work-based pensions provide a recurring lifetime payment. That means regardless of how long you live, that income will keep coming. And typically the longer you defer to start your benefit, the larger the monthly check will be.
While it can be tempting to claim your Social Security benefits the moment you are able to at age 62, delaying your Social Security start date can substantially increase the amount you receive monthly. Maximizing your Social Security or pension payout provides you with a much softer cushion to land on if your savings run thin.
Have a well thought out withdrawal plan
A smart and effective withdrawal plan is another way of combating the risk of running out of money, sort of like creating a withdrawal budget. One rule of thumb cited extensively over the last 20 years that seems to hold up is called the ‘4 percent rule’. This rule suggests that a well balanced conservative growth portfolio of stocks and bonds can support a 4% withdrawal rate, good times and bad, and you will be able to closely maintain the size of your initial retirement nest egg over the course of your retirement years.
For example, let's say you have a $1 million retirement account on the day you retire. This rule of thumb suggests that a well balanced portfolio will be able to support a withdrawal rate of $40,000 per year over the course of your lifetime.
Even though the “4 percent rule’ is a good starting point, it is simply a rule of thumb. Ultimately the best tactic is to run retirement modeling software with an experienced advisor. A good advisor can project, interpret, and explain a number of scenarios specific to your own portfolio and situation, and most importantly guide you in developing a numbers based withdrawal plan that may help you achieve those best laid retirement goals.
Budget your expected expenses
Many of my clients have become lazy when it comes to budgeting, their earnings are sufficient enough and lifestyles conservative enough during working years that budgeting is simply never needed as there always seems to be enough money in the checking account to cover expenses. However I remind my retirees early on that it may not be quite as simple once on a fixed retirement income. Getting in the habit right away with tracking expenses BEFORE retirement would be a good place to start.
An expense area to pay particular attention to is Health Care. During working years, most people have healthcare insurance that is quite predictable (even though not cheap). However once you reach the age of Medicare, out of pocket costs can vary widely.
You probably assume correctly that as people live longer, they’ll have increased healthcare costs the older they become as their bodies break down. And unfortunately, the cost of providing that care is also increasing at a clip faster than the general inflation rate. In fact, health care spending is expected to rise more than 5% per year through 20282.
In addition to typical medical expenses, nearly 70% of retirees will also need long-term care3. These combined expenses of health and long term living care can put a serious strain on your retirement savings well down the road from the day you first begin retirement. These costs are very hard to predict, but it's crucial to address and plan for them well ahead of time.
Risk 2: Market volatility
Perhaps you’ve heard once or twice that the stock market fluctuates. Big surprise, right? While this might not be news to you, what may surprise you is that the way you address market volatility in retirement should differ from how you handle it during your accumulation years.
While you are saving for retirement, volatility is less of a concern primarily because you are putting money into your savings, often dollar cost averaging4 through payroll contributions. When the market dips, no big deal, you just make your next deposit on queue, and that money is invested into cheaper shares.
In retirement, the situation is reversed. You are now pulling money out of your retirement savings. When the market dips, you still need to sell shares to have cash to withdraw, but now those shares are cheaper, locking in losses.
Before we jump into strategies for handling volatility in retirement, it’s important to remember that markets are going to naturally fluctuate as the economy ebbs and flows. Even though it might seem like the stakes are higher once you're in retirement, the fundamental rules of staying calm and not overreacting to market volatility still holds. You will never sell all of your shares at the peak of the market. Staying mindful of this will help you stay calm and prevent you from making snap decisions or abandoning your gameplan when the market gets jittery.
So how do you plan for volatility and ensure you protect yourself while not overreacting to insignificant movements?
Match your investment mix to your stated risk tolerance
The first way to plan for volatility is through your investment plan. This is why a proper risk tolerance assessment and choosing the right investment mix are crucial. You will want to take some risk to make sure your investments grow enough over the long term, but if you invest too aggressively, then you may be overexposed to the possibility of a poor market. As a rule of thumb, retirees should have somewhere between 40% to 75% of their savings in stocks, with the rest in other securities like bonds, of course every investor has a different appetite for risk.
Your withdrawal plan
A common approach is to withdraw a specific percentage of your retirement savings each month on a predetermined date, sort of like dollar cost averaging in reverse! This approach takes out the need to time the market, the randomness of the market coupled with the static monthly withdrawal rate will statistically even out the need to time the market.
You can also address market volatility by adjusting the amount of your withdrawal plan. If you start with a certain monthly withdrawal percentage, 4% for example, consider setting up some “guardrails” that will allow you to make adjustments to that monthly income amount that is based on how well the underlying portfolio is performing.
Think of it like the bumpers on a bowling lane. The bumpers have no effect as long as the ball is rolling straight down the lane. But if the ball hits a bumper (account value falls substantially due to a protracted bear market), it corrects the ball and pushes it back on course (adjusts the monthly withdrawal in line with original withdrawal rate, providing a better opportunity for the portfolio to recover).
Again, let’s take that 4% withdrawal rate as an example. You might decide to set guardrails at 3% and 5%. Meaning if your inflation-adjusted withdrawal in a given year would be more than 5% of your current savings balance, then you don’t take the full withdrawal. Instead, you might take $.90 for every $1 you had planned to withdraw. While that means taking a slight pay cut, it can go a long way in protecting your savings long into the future.
Of course, it works the other way too. If your account grows much larger than your withdrawal, this strategy lets you know when it might be safe to spend more from your savings. If you hit the lower guardrail, you might consider taking $1.10 for every $1 you otherwise would have.
The important thing to remember about the guardrail strategy is that it provides a structured and predetermined way of redeeming money and making adjustments to the amount in a way that takes the ever lurking emotion out of the decision making process.
Risk 3: Inflation
As Yogi Berra put it, “A nickel ain’t worth a dime anymore.” Inflation will impact your retirement, but fortunately, you can reduce its impact through proper allocation planning. The nice part is, most of what you do to address the other risks we have discussed already will also provide some protection from inflation.
Maximize inflation-adjusted sources of income
Social Security planning is essential here. Spend some time researching your election options. Don't jump in and take the easy single life benefit at age 62. A properly designed benefit not only provides you with a guaranteed income source, but it also adjusts with inflation automatically. When inflation is higher, your Social Security benefits are increased relative to the government's stated CPI numbers. As recently as 2021, the annual cost of living adjustment was 5.9%5!
Keep a long-term investment focus with a good asset allocation policy
Historically, the biggest fear for many retirees is the risk of inflation. Why, because most retirees are on a fixed income and unable to ‘create’ more income like they were able to do during their accumulation years (by taking on a second job or working some extra overtime).
However a close second to inflation fear is market losses from periodic bear markets. The knee jerk reaction here is to panic and sell when stocks go down, however stocks historically give you the best chance to keep pace with inflationary pressures on goods and services.
Remember, by the time you retire, you’ll likely still have several decades ahead of you and hence your investment time frame is equally as long. You don’t need to invest as if you’d have to withdraw your entire savings next year. Historically, the stock market has averaged returns exceeding inflation over the long term, plan as if that were going to continue.
Risk 4: Taxes
Taxes are a significant and often under considered cost to long term retirement performance. Unfortunately, taxes won't go away once you hit retirement and congress’s penchant for radical rule changes can make it hard to plan for. However, there are a number of strategies often utilized by retirees that can help maximize their after tax returns.
Taxes on retirement accounts6
The beauty of traditional IRA accounts (and 401k contributions) is that you don't pay tax on the contribution until you withdraw the funds, essentially deferring your tax obligation into the future. However the downside is that eventually someone (yourself or a beneficiary) will have to pay tax on both the contribution and the accumulated growth. These traditional retirement account withdrawals are taxed as ordinary income. Having significant money saved in 401(k)s and IRAs is great, but it means you may have a significant tax burden during the years you have less disposable income.
Roth Conversions
If you are nearing retirement and most of your savings are tax-deferred, then you can get ahead of the pending tax obligation by gradually converting some of your IRA money into a Roth IRA each year. You’ll pay taxes on the converted amount now, but it can help reduce your fixed tax burden later by giving you a more balanced source of asset from which to draw from. Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
Taxes on Social Security
Your Social Security benefits are taxed as income, too. The caveat here is that not all of it is taxable. Depending on where your combined sources of retirement income come from, you may need to pay taxes as little as 0% to as much as 85% of your Social Security benefits to taxes7. Once again, Roth conversions can come to your rescue because a tax-free distribution from your Roth IRA doesn't count toward determining the taxability of your Social Security.
Taxes on investments
Investment account taxes are crucial to understand because capital gains tax rules differ substantially from income tax rules. Gains from investments held less than one year are taxed as income, while gains from investments held for longer than a year are taxed at lower capital gains rates. Currently long-term capital gains tax is a maximum of 20% and potentially as low as 0%8.
Tax Loss/Gain Harvesting
Beyond pushing your capital gains into long-term territory, you can also reduce your taxes by tactically choosing when you realize gains.
Tax-loss harvesting means you deliberately sell investments that have declined in value so you can take the tax deduction now. These capital losses can offset capital gains created elsewhere when rebalancing a portfolio. For tax purposes, and with some hard work and consideration, we can net out the tax effect of both transactions.
Tax-gain harvesting can be just as helpful, especially when the market has climbed for a long time, and offsetting losses may be hard to come by. To take advantage of a lower tax rate, you can harvest gains in low-income years, such as the few years between a first spouse's retirement and the second spouse’s.
Gifting Appreciated Stock
Another opportunity provided by the IRS is to ‘gift’ your appreciated stock to a 501(c)3 charity. This technique works especially well if you have historically given annually to a charity (like a church). Since charities are non taxable entities, you can give to your favorite charity the shares of appreciated stock, and let the charity instead sell the shares once they receive the gift. You as the donor avoid paying any tax on the built up gain, and the Charity can sell the shares at no tax owed…a true win win!
Qualified Charitable Distribution (QDC)
A similar strategy to gifting appreciated stock is to give IRA required minimum distributions (RMD) to a charity. Once you turn 72, the IRS requires investors to redeem a certain percentage of their IRA’s. Even if your beneficiary inherits your IRA, they too will be required to withdraw a minimum dollar amount. A qualified charitable distribution is the one exception the IRS provides to the RMD rule. If you give your RMD to charity after the age of 70 ½, then you will not need to claim the RMD as income on your tax return.
Medicare Premium Penalty
One area that often gets overlooked by retirees is the Medicare premium adjustment. While most people are focused on investment transactions that minimize marginal tax brackets, many forget to consider the steep adjustment Medicare charges for higher incomes, which can include RMD’s, Social Security, and dividends and capital gains.
State taxes
Depending on where you live, don’t forget to figure in your state taxes, as well. Generally, state tax laws function similarly to federal tax laws. A common difference between the state and federal levels is whether Social Security is taxed and how9. Of course, tax laws vary from state to state, so make sure you understand your local laws or talk to a tax professional.
Also, some States do offer beneficial income tax or real estate tax rates, however don't overlook other costs that might offset these savings such as a particular State’s increased energy costs, insurance costs, or sales tax costs.
Preparing for retirement risks can make a world of difference in the longevity and success of your retirement plan. While risks can’t always be avoided outright, they can be managed, effectively extending the longevity of your portfolio and hence the quality of your retirement.
The sooner you start preparing for retirement, the less likely you will be caught off-guard and stuck paying for the consequences of an unprepared gameplan. A trained and experienced retirement advisor can review all the risks unique to your situation and ensure you are as prepared as possible.
Retirement planning can help ensure a smooth transition into and through retirement. Watch for additional posts and planning tips in the weeks ahead, or contact us any time to discuss your planning needs.
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