If you protect yourself from these three risks to your retirement portfolio, then you set yourself up for success in retirement.
In order to succeed in retirement, you must reduce the risks to your portfolio.
However, you can’t reduce what you don’t understand. So I’m going to explain the three biggest risks to your retirement, how they affect your retirement plans, and how to protect yourself.
The three biggest risks to your retirement finances are:
There are other risks in retirement too, but if you protect yourself from these three, then you protect yourself from many of those as well.
Inflation is one of the most powerful forces working against your retirement plan.
Every year, the dollar buys less and less. Many people plan their income for the first year of retirement, forgetting that they probably will be retired for 20-30 years. The first few years may be fine, but what happens when costs double? Triple?
Here’s an inflation chart showing how costs have increased over time:
If you only had planned on sustaining $42,000 of income when you retired in 2000, your standard of living would be cut almost in half. With an average retirement length of twenty-five years and an inflation rate of 3%, the cost of living more than doubles by the end of retirement. Many who retired in the year 2000 are still alive today.
Additionally, inflation can have an even greater effect on retirees than it does on the general population:
- Retirees buy more services than goods, and services historically have inflated at a higher rate than goods.
- Retirees spend more on medical care, and medical inflation is twice as high as general inflation
How Do You Protect Retirement Income from Inflation?
Stocks offer the best protection from inflation.
A retirement portfolio shouldn’t be all stocks, but a proper portfolio has 50%-60% in stocks. That mix offers inflation protection while still having enough in bonds to buffer from downturns.
Why do stocks tend to protect you from inflation in the long run?
Inflation is the value of the dollar going down over time. As the dollar decreases in value, companies have to raise prices to keep up with their costs. So inflation means prices going up.
But what do you own when you have stocks? Companies. When you own a stock, you own the companies raising prices.
Other types of investments don’t offer the same level of inflation protection.
Fixed income products like savings accounts, CDs and bonds do not protect well from inflation. They offer fixed payments without opportunity for growth. Insurance products also struggle to protect against inflation due to the additional insurance costs and the requirements to invest in fixed income. Some offer inflation protection riders but at additional costs.
Here’s what investment returns have looked like over the last 35-years:
The lowest line is inflation, and the green line right above it is the return of short-term government bonds, which have about the same return as CDs and savings accounts. The dark blue line on top is the S&P 500.
Bonds don’t offer much more than inflation. And in some periods, bonds have lost money after inflation.
The long-term inflation protection of stocks is one thing you get in return for putting up with the volatility of the market.
Most people underestimate longevity risk—the risk of outliving your income.
As technology and healthcare improve, people are living longer. The longer you live, the more stress you put on your portfolio. As costs continue to rise, you continue withdrawing assets and are subject to the risk of increased health care costs.
For example, let’s look at the difference in total spending for a 20-year retirement compared to a 30-year retirement.
If you need a $60,000 annual income in retirement, and inflation is at 3%, here is the total sum of all your spending in retirement:
- 20-year retirement: $1,612,222
- 30-year retirement: $2,854,524
The spending for a 30-year retirement almost doubles that of a 20-year retirement. The longer you live, the more money you need.
For a 60-year-old, you have:
- A 50% chance of living to age 82
- A 25% chance of living to age 90
- A 10% chance of living to age 95
For a couple, both age 65, there’s a 50% chance that one of them makes it to age 92.
And those are averages. If you are in good health, your chances are even higher.
Don’t count on dying early—even if your parents didn’t make it far into retirement. It’s always better to err on the conservative side. To set yourself up for retirement success, plan on living a long time.
You don’t want to be 85—and in perfect health—only to run out of money because you thought you would live to 82.
The Costs of Long-Term Care
The other factor in longevity risk is health care.
Long-term care costs can be significant. It’s much easier on your pocketbook if you die quickly than if you end up with an extended stay in a long-term care facility. Unfortunately, you can’t plan for that, so it’s important to be prepared.
According to Genworth Financial, 70% of people will require long-term care in their lifetime, and 40% of those over age 65 will enter a nursing home facility.
The facilities aren’t cheap:
- Average cost of an assisted living facility: $48,612 per year
- Average cost of a private nursing home room: $102,200 per year (2020 numbers)
The cost can vary substantially depending on the type of care involved, your location, and the quality of the care, but these numbers give you a general idea of the costs.
Additionally, the average length of stay in a nursing home is about two-and-a-half years. Multiply the annual costs by that length of time, and you could easily spend $255,500 or more on nursing home care.
Don’t plan on Medicaid covering those costs. Medicaid will pay for a long-term care facility, but you don’t have much control over where you stay or the quality of the facility. Also, you must have almost no assets left before Medicaid will start to pay for your care. You can’t give the assets away, either, because they will count any assets gifted within the last three years.
For these reasons, Medicaid is generally a last resort for your long-term care costs.
How Do You Prepare for Longevity Risk?
Several steps can help you prepare for longevity risk.
Next, you must decide how you want to protect against the possibility of long-term care costs. You have two choices: 1. Self insure or 2. Purchase long-term care insurance.
Self insurance means that you have enough assets to protect your income stream from an extended stay in a long-term care facility.
There are no exact rules of thumb for knowing if your income stream can withstand a long-term care stay. There are too many variables. Still, you need to know your retirement expenses. Then you can see how a long-term care stay would impact your retirement budget. Then, if you know how much income you can have in retirement, you can compare that to your retirement expenses to see if you are able to be self-insured. This is an area where you will need professional help.
The other option to protect yourself from long-term care risks is purchasing a long-term care insurance policy (LTCI).
An LTCI can be a great way to shelter your assets from a prolonged nursing home stay. But as with any decision, there are pros and cons. I won’t get into the details of how these policies work, but I will offer a short list of considerations for making the decision to purchase LTCI or not.
The decision to purchase LTCI hinges on two main factors:
- What kind of stress would a nursing home stay put on your portfolio?
- How expensive are the premiums?
You must weigh the risk to your portfolio with the cost of the premiums.
Often, wealthier individuals like to purchase LTCI, even though their portfolio can withstand the costs of long-term care. They can afford the premiums, and they don’t want to see their assets spent on a nursing home. In other cases, individuals whose portfolios might be depleted from the costs of long-term care may want to purchase the insurance to protect the inheritance of their heirs, even though the premiums are costly.
Others may have enough assets to cover long-term care in all but the worst-case scenarios, and so they would rather accept the risk and eschew paying the premiums.
This is a decision that is up to you and based on your values.
Sequence of Returns Risk
Many people focus solely on the annual return of their portfolio, but the order of the returns often matters just as much as the overall return itself.
Particularly, the returns of the first few years of retirement are more crucial than later returns. Because you are withdrawing money each year from your investments, the higher the market value is, the fewer shares you have to sell to generate income. The lower the market is, the more shares you have to sell to get the same income.
For example, this chart shows how share price affects the number of shares you need to sell to generate $10,000 of income.
The lower the share price, the more shares you need to sell.
|Shares to sell:||250||200||167|
What does this mean for your returns in retirement?
If the low returns—aka low share prices—occur in the first few years of retirement, then you must sell more shares in the beginning than you normally would. In this case, you have fewer shares to last you throughout retirement, decreasing your overall chance of success.
Another way to think about it is that recovering from a 50% downturn requires a 100% return.
If you have $100,000, a negative 50% return in year one of retirement leaves you with $50,000. A 50% return on that $50,000 only gets you to $75,000. You need a full 100% return to get back up to $100,000.
But in retirement, you still need income even when the account value is down 50%. If you take the money out while the market is down, you now need a return even higher than 100% to get back to where you were.
How Do You Protect Yourself from Sequence of Returns Risk?
With a properly structured portfolio, you soften the effects that downturns have on your investments.
First, different asset classes will be affected differently by the downturn than by the recovery, so there’s less of a risk that any one asset class tanks and stays down for long. Plus, there’s a greater chance that you recover more quickly, because some assets will benefit from the recovery more than others.
Still, major downturns will affect all asset classes.
Another benefit of a proper retirement portfolio, though, is having a significant amount in bonds. When stocks are down, you can pull income from bonds, giving the stocks time to recover.
With 40% of your portfolio in bonds, withdrawing 4% of the account for income means that you have ten years of income in bonds. Historically, that’s been enough to recover from any downturn — even the Great Depression.
Another way to protect yourself from sequence of returns risk is to build flexibility into your income needs.
This may mean that you have to cut back on your budget for a time while the market recovers. Research has shown that you can increase your success rate in retirement by adjusting your withdrawal rate based on market conditions. For example, when the market is down you can cut expenses by 10%, and when the market is up you can increase your budget by 10%. That flexibility decreases the number of shares you need to sell in down markets.
Finally, we recommend keeping an emergency fund, even in retirement.
A retirement emergency fund helps cover unexpected expenses, but it also can be used in times when the market is down.
Think of a market downturn like a temporary pay cut. During your working years, if you become unemployed, you use an emergency fund to cover living expenses. In retirement, you can use an emergency fund in the same way—if there’s a market downturn, use the emergency fund to temporarily cover expenses.
Then, when the market recovers, you can replenish the emergency fund with some of the gains if needed.
By Michael Sharpnack
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*Advisory services offered through Paul Winkler, Inc. (‘PWI’), an investment advisor registered with the State of Tennessee. PWI does not provide tax or legal advice: please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase of sale of any securities. Information we provide on our website, and in our publications and social media, does not constitute a solicitation or offer to sell securities or investment advisory services, or a solicitation to buy or an offer to sell a security to any person in any jurisdiction where such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.