The longer you spend in retirement, the harder it becomes for you to be comfortable about whether your assets will last. Financial, personal, and public policy risks threaten your hard-earned gains. In planning for and living your retirement, it’s imperative for you to both recognize and understand the risks that lie ahead for you — and how they could undermine the security and comfort you and your loved ones expect for your golden years. That’s why we launched our Retirement Is For Living planning process—to help you recognize and consider all of the various risks you may encounter in the forthcoming decades.
As the recent COVID-19 crisis suggests, even carefully designed retirement plans are susceptible to unexpected events. Markets regularly go up and down, the Federal Reserve cuts interest rates, and the rising specter of inflation constantly looms over modern economies. All of these financial risks threaten the hard earned gains you’ve made for yourself during lifetime of work. However, with thoughtful planning, the adverse consequences from many financial risks can be reduced or mitigated. Understanding post-retirement risks and integrating them into your retirement planning is the first step in ensuring that your Retirement Is For Living.
Risk from Declining Financial Markets
As recent months have shown, stock market performance can drastically affect your retirement portfolio. Over long periods of time, investments in U.S. equities have outperformed all other types of domestic financial investments, including treasuries, corporate bonds, and real estate(1). But stock market returns are still highly variable from one year to the next — and can show returns lower than alternative investments over the short- and medium term.
Variation in market returns can be doubly problematic for retirees. First, those already in retirement don’t have working years to make up for any shortfalls. Second, the time horizon for a retiree is shorter than that of younger workers. While most volatility evens out in the long run, that can take decades.The existence of these kinds of risk means that there is a continuing and crucial role for diverse retirement income streams even for workers who were comfortably upper-middle-class for much of their careers. Optimizing Social Security and pension offerings or integrating annuities into your portfolio can help insulate your financial future from market downturns. Our guide to social security and medicare can help get you started.
Sequence of Returns Risk in Retirement
In addition to whether your portfolio goes up or down in value, the order of those returns can have major ramifications for your retirement. Called “sequence-of-returns” risk, this means that downturns in your early years can matter a lot more than downturns later during retirement. Poor returns early in your retirement can force you to choose between three options that are far from ideal. You can dial back your withdrawal rate and adjust your lifestyle, take on more risk than you would otherwise to try to recoup the losses, or you can maintain your withdrawal rate and risk running out of money later.
It follows that the market returns you experience near your retirement date are critical. Retiring at the start of a bear market can be dangerous for the reasons outlined about. The average market return over a given 30-year period often approaches 10%, but if negative returns are experienced in the early stages of your retirement after you have started spending from your portfolio, your assets can be depleted rapidly. Nowhere was this more evident with people who retired from 2005-2008.
The dynamics of sequence risk suggest that the retirement prospects for a particular group of retirees could be jeopardized by a recession early in retirement. We help savvy investors plan for this in two ways. First, with investment design that contains lower volatility than the markets. Investors do better with lower standard deviation on their investments (i.e. do better in the poor markets). Second, we match an asset allocation to a client’s risk tolerance as well as to their needs. With the Envision investment planning process we can determine the lowest amount of investment risk a client needs to take to reach their goals.
Low Interest Rates = Low Returns
The growth of a person’s retirement fund depends, in part, on the direction of interest rates. While low-interest-rate environments may be great for younger individuals looking to borrow, they aren’t ideal for older folks who are looking to save their hard-earned money, especially in conservative investments. Banks and other financial institutions usually pay low returns when prevailing interest rates are low.
What lower interest rates have done is force investors close to or in retirement to take on more equity risk to get the returns they need to live the life they want to live. And Risk is defined as account value variability. This is what Magellan Financial’s Retirement is For Living approach is all about: Helping clients design a portfolio that better positions them to get 4% returns in a 2.5% world. Low rates make planning more important as the investor should know how much risk they need to take to reach their retirement goals.
The Specter of Rising Inflation
Inflation is the long-term tendency of money to lose purchasing power. It can have a particularly negative effect on retirees because it chips away at retirement income in two ways: by increasing the future cost of goods and services and by potentially eroding the value of assets a retiree has saved to meet those costs It’s difficult to predict the cost of living in the future. When you’re working, inflation can be addressed by increased salary. In retirement, your resources are often fixed.
As the U.S. Department of Labor explains in a retirement planning booklet distributed in 2014, “If your money is not earning more than the rate of inflation, you will lose part of your nest egg’s buying power.”
To make matters worse for retirees, the one exception to the country’s relatively low inflation rate is the rising cost of health care. According to the Labor Department, medical costs have risen more rapidly than inflation during the last two decades, and studies estimate that retirees will spend 19 percent of their income on health care by 2039. There are various ways to address this risk, such as choosing investments that provide insurance against inflation or the potential for growth and adding a cost-of-living rider to an annuity to account for inflation.
Pension and Other Prior Work Business Risks
A traditional pension plan defines benefits as an annuity dependent on an employee’s pay and/or service while working for the plan sponsor. Aside from the impact of COVID-19 on employment, market volatility does not directly affect the amount of benefits provided under this type of plan. However, volatility may affect the availability of optional forms that accelerate payment (i.e., lump sums) if the plan’s funded status drops below 80%.
Market-based pension plans define the growth in account balances based on the change in the value of the underlying trust. These plans have the highest chance of impact from COVID-19 for the types of pension plans described in this article, but the ultimate impact on participants will depend on several factors:
- Asset allocation of trust (i.e., share of stocks versus bonds).
- Depth and duration of any global recession that may result from COVID-19.
- Timing of retirement – If an employee does not expect to retire for many years, the impact of COVID-19 will likely be less than that of an employee planning to retire soon under this specific type of cash balance plan.
Live the Retirement You’ve Been Working Toward
The current uncertainty surrounding COVID-19 means you have to be as vigilant as ever to protect the retirement you’ve been working toward. Understanding post-retirement risks related to financial loss and then integrating them into your retirement planning is the first step in ensuring that your Retirement Is For Living. The timing of when you retire related to market downturns, interest rates, and inflation can derail your retirement. You need someone in your corner to help mitigate against those risks.
Magellan Financial believes that professional wealth management has only one definition of success: when our financial services allow our clients to realize their lifestyle and financial goals in retirement. Our thorough, thoughtful, risk-based strategies are designed to support your greatest objectives, so you have the freedom to enjoy them. After all, your Retirement Is For Living.
The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates The material has been prepared or is distributed solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.
When considering rolling over your QRP assets, key factors that should be considered and compared between QRPs and IRAs include fees and expenses, services offered, investment options, when you no longer owe the 10% additional tax for early distributions , treatment of employer stock, when required minimum distributions begin and protection of assets from creditors and bankruptcy. Investing and maintaining assets in an IRA will generally involve higher costs than those associated with QRPs. You should consult with the plan administrator and a professional tax advisor before making any decisions regarding your retirement assets.
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