Generating enough income in retirement calls for managing risks to that flow of cash. Retirement savers can’t do that unless they know what those risks are. Financial planners identify these eight prime retirement income risks and provide guidance for reducing them.
1. Timing: the risk you’ll retire during a bear market.
Dallas-based certified financial planner Scott Stratton offers this scenario: The market plummets 30 percent the year that you retire and you start withdrawing 4 percent annually from what was previously a $1 million portfolio. “In 12 months, your portfolio falls to $660,000, and 4 percent is no longer a sustainable withdrawal rate,” said Stratton, president of Good Life Wealth Management.
One remedy suggested by Fort Worth, Texas, CFP Tim Estes, is to have a robust cash emergency fund to tide you over without tapping retirement accounts. “If your expenses are $60,000 a year and you have $60,000 in a money market, who cares if the market goes down?” said Estes, founder and CEO of Estes Financial. “Because it does come back.”
2. Inflation: the chances that inflation will erode your purchasing power.
“This is a huge risk, as retirement is becoming longer,” Stratton said. “If inflation is just 3 percent, your cost of living is going to double every 24 years — and some costs, like health care, are growing at much more than 3 percent.”
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Estes recommends equities as an inflation counter. “You have to have some of your money in the stock market so you can get returns above inflation,” he said. With inflation running about 3.5 percent a year, a moderate portfolio returning 6 percent to 7 percent keeps up with inflation even after withdrawals, he says.
3. Longevity: the chance you’ll outlive your money.
Worries about outliving retirement savings are partly due to longer life expectancy, says financial planner Charisse MacKenzie, president of Saturn Wealth in Gilbert, Arizona. “Today we have a 1 in 4 chance of one person in a couple living to 95,” she said.
To mitigate this risk, MacKenzie suggests delaying claiming Social Security benefits until the maximum benefit is reached at age 70. “The longer you expect to live, the longer you should delay Social Security,” she said.
4. Interest rates: the risk you won’t be able to get adequate returns on safer debt investments.
Although rates are rising, current fixed-income returns lag well behind historical norms. This provides a potent challenge to people seeking retirement income. Estes suggests high-dividend stocks as alternatives to puny bond yields. “I’ve got investments that I think are relatively safe paying anywhere between 5 [percent] and 7 percent,” he said.
5. Investor behavior: the risk you’ll dump stocks in a temporary downdraft.
Left to their own devices, individual investors tend to sell low during bear markets. That is one reason MacKenzie suggests relying on a presumably more dispassionate professional money manager. “People are too emotional about their own money,” she said. “It’s wise to have someone handle it for them.”
6. Withdrawal rate: the risk of taking out too much, too soon.
Four percent has long been the considered the safe withdrawal amount retirees can pull from accounts annually without risking running out of money. Today’s outlook for lower returns on all sorts of investments has many experts questioning that rule.
Currently the safe percentage can vary, depending on whether a retiree expects other income from pension or annuities, MacKenzie says. Financial planning software uses simulations to produce more reliable figures in complex situations. “We put all their assets and income expectation in there and show them with their existing strategy how long their money will last,” she said.
7. Cognitive decline: the risk of becoming unable to manage your finances.
Even a modest level of age-related cognitive impairment can make managing an investment portfolio challenging, to say the least. MacKenzie says defusing this risk typically involves preparing a health-care power of attorney in advance. “Before you get there, have somebody who can take over your account and can make decisions for you if you can’t yourself,” she said.
“Even when you have Medicare, you could have substantial out-of-pocket health expense.”
8. Health-care costs: the chances of major medical bills.
To avoid having medical bills drain a retirement account, delay retiring until age 65 when Medicare eligibility kicks in, Stratton suggests. “Even when you have Medicare, you could have substantial out-of-pocket health expense,” he added. Long-term care is a potentially high-impact risk, he says. To reduce it, he suggests getting long-term care insurance, preferably in your 50s when premiums are lower.
Other retirement risks may also crop up. Estes sees future tax rates as a potential threat to savers with well-stocked individual retirement accounts and other tax-deferred accounts. “Right now, taxes are at the lowest rates we’ve had in decades,” he said.
To avoid the risk of higher taxes in the future, Estes has many clients converting to Roth IRAs.
— By Mark Henricks, special to CNBC.com