The road to retirement is never smooth, especially when it comes to developing a sustainable retirement income plan. Four challenging impediments to a successful retirement include longevity risk, long-term care risk, “sequence of returns” risk, and public policy risk. Understanding these risks and industry-best practice solutions will pay big dividends in the creation of a more secure retirement income plan.
Longevity risk is complicated, because it involves securing income for an unpredictable length of time. While the average life expectancy of a male at age 65 is 84 and of a female is 86, averages fail to tell the whole story. If you plan for a client to live to the average life expectancy you will be wrong half of the time, not an acceptable failure rate when it comes to retirement planning. Roughly 25 percent of people alive at age 65 will live to age 90 and over 10 percent will live to age 95. Factor this in for a couple and there is greater than 50 percent chance one of them will be alive at age 90. If this comes as a surprise, know that most people underestimate their own life expectancies.
Exceeding one’s life expectancy puts significant strain on their ability to meet their income needs throughout retirement. Many solutions are available to help mitigate the risk of outliving the retirement income portfolio.
First, consider deferring Social Security benefits to increase benefits. Each year benefits are deferred beyond full retirement age, the benefits will increase by 8 percent each year up until age 70. Additionally, these larger benefits will continue for life, so the longer the person lives, the better it is to defer. Of course, in order to get more money with this strategy the person needs to live past a break-even point, where it would have been beneficial to claim early. However, deferring Social Security can be an effective strategy for anyone who expects to live well into his 80s or 90s as they will receive more money and will be better protected against inflation and longevity risk.
A second solution to offset longevity risk is the purchase of an annuity. Some annuities, known as immediate annuities, will provide income starting today. Others, known as deferred income annuities are built specifically to address longevity concerns. A special type of deferred income annuity can now be purchased inside of an IRA, known as a qualified longevity annuity contract (QLAC), which can prevent someone from running out of money if they exceed their life expectancy.
Longevity risk often goes hand-in-hand with another major risk, long-term care risk. Long-term care is a topic that most people find unpleasant to discuss. Declining health and mental capacity is an inevitable fact of life for most people. Nearly 70 percent of those who live to 65 will eventually require some sort of long-term care. However, most of that care will not be in an institutional setting but is provided by unpaid family members in an informal setting. When a nursing home or assisted living facility becomes a necessity, it can be devastating financially as annual costs often exceed $100,000.
To cover the potential costs of long-term care, set up a plan well in advance of needing care. Long-term care planning does not simply involve the decision as to whether or not to buy long-term care insurance. It requires a discussion with family and friends about the type of care that is desired, where care should be delivered, and how care will be paid for. Long-term care expenses can be paid for out-of-pocket, through the purchase of a long-term care insurance contract, through government programs (Medicaid), or through other hybrid financial service products that combine the benefits of life insurance or an annuity with long-term care insurance. Another option is to pre-pay some of these costs by moving into a continued care retirement community (CCRC).
“Sequence of Returns”
Another major retirement risk known as “Sequence of Returns” (SoR) risk presents a unique challenge because it first rears its ugly head early in retirement when assets need to be sold to create income. Investment returns are unpredictable, and negative returns in the early years of retirement can increase the likelihood that one will eventually run out of money.
SoR risk is tied in part to the volatility of the investment portfolio. One way to reduce SoR risk is to reduce this volatility, especially in the first few years of retirement. Maintaining a higher allocation of bonds than stocks in the few years leading up to and immediately following retirement is one approach. Another strategy is to establish an income source that is independent of the investment portfolio, like a term certain annuity which provides a set amount of income. Another solution is to leverage home equity to help fund the early years of retirement if the market is down. A HECM line of credit allows the homeowner access to his home equity and is available as early as age 62. This allows the homeowner to preserve investment assets for later periods when the market rebounds, while maintaining sufficient income during early retirement.
Another risk that can have a huge impact on retirees is public policy risk. Retirees experience a sense of helplessness when the Government decides to raise taxes, cut benefits, or modify Social Security and Medicare. Minimize this risk by diversifying the retirement savings and try to reduce reliance on a single source of retirement income. Such steps can minimize the impact that any one public policy change will have. Lastly, remain attuned to the ever-changing retirement income planning landscape, as programs like Social Security and Medicare are sure to evolve and change over the next 30 years.
While these risks present challenges, staying up to date with the best strategies to manage retirement risks is a way to turn these potential roadblocks into minor speed bumps. Comprehensive planning which includes building safeguards into a retirement income plan to protect against risk is the best route to a financially secure retirement.