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  • 7 risks for retirement income planning

    June 19, 2015 by Wade Pfau

    Retirement income planning has emerged as a distinct field in the financial services profession. And while it suffers from many growing pains as it gains recognition, increased research and brainpower in the field have benefited retirees and those planning for retirement. One matter has become even clearer than before: The financial circumstances facing retirees differ dramatically from pre-retirees.

    Those entering retirement are crossing the threshold into an entirely foreign way of living, where they are vulnerable to several risks more uniquely felt by retirees:

    1. Reduced earnings capacity: Retirees face reduced flexibility to earn income in the labor markets as a way to cushion their standard of living from the impact of poor market returns.

    2. Visible spending constraint: While investments were once a place for saving and accumulation, retirees must try to create an income stream from their existing assets as an important constraint on their investment decisions. This amplifies investment risks by increasing the importance of the ordering of investment returns in retirement.

    3. Heightened investment risk: Retirees experience heightened vulnerability to sequence-of-returns risk once they are spending from their investment portfolio. Poor returns early in retirement can push the sustainable withdrawal rate well below what is implied by long-term average market returns.

    The financial market returns experienced near one’s retirement date matter a great deal more than most people realize. Retiring at the start of a bear market is incredibly dangerous. The average market return over a 30-year period could be quite generous, but if negative returns are experienced in the early stages when someone has started spending from their portfolio, wealth can be depleted rapidly through withdrawals, leaving a much smaller nest egg to benefit from any subsequent market recovery, even with the same average returns over a long period of time.

    The dynamics of sequence risk suggest that the retirement prospects for a particular group of retirees could be jeopardized by a prolonged recessionary environment early in retirement even without an accompanying economic catastrophe. Particular retiree groups could experience much worse retirement outcomes than those retiring a few years earlier or later, and devastation for a group of retirees is not necessarily preceded or accompanied by devastation for the overall economy.

    4. Unknown longevity: The fundamental risk for retirement comes in the form of unknown longevity. The length of one’s retirement could be much shorter or longer than a person’s statistical life expectancy. A long life is wonderful, but it is also more costly and a bigger drain on a retiree’s resources. How long will a retirement plan need to generate income? Half of the population will outlive their statistical life expectancy, and some will live much longer.

    5. Spending shocks: Unexpected expenses could relate to any number of matters, including health and long-term-care needs, fraud and/or theft, an unforeseen need to help other family members, changes in public policy, divorce, changing housing needs, home repairs and rising prescription costs. Retirees must preserve flexibility and liquidity to manage unplanned expenses. When attempting to budget over a long retirement period, it is important to include allowances for such contingencies.

    6. Compounding inflation: Retirees face the risk that inflation will erode the purchasing power of their savings as they progress through retirement. While it may not be noticeable in the short term, even low inflation can have a big impact over a lengthy retirement, leaving retirees vulnerable. Even with just 3% average annual inflation, the purchasing power of a dollar will fall by more than half after 25 years.

    7. Declining cognitive abilities: Finally, a retirement income plan must take into account the unfortunate reality that many will experience declining cognitive abilities, hampering portfolio management and other financial decision-making skills. It will become increasingly difficult to make sound portfolio investment and withdrawal decisions as one enters advanced ages.

    In addition, many households do not share management of personal finances equally. When the spouse who manages the finances dies first, the surviving spouse can run into serious problems without a clear plan in place. The surviving spouse can be left vulnerable to financial predators and make other financial mistakes.

    Not all is bleak, as retirement plans can be built to manage these varying risks. This is why retirement income planning is now emerging as a distinct field.

    Originally Posted at InvestmentNews on Jun 15, 2015 by Wade Pfau.

    Categories: Industry Articles
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