Investors today face a multitude of threats to their financial security. Low-interest rates and historically high valuations are a concern for many investors. In addition to the risks faced by working investors, retirees face a unique and daunting set of hazards.
Throughout a person’s working life, they may have been concerned about the financial impact that their death could have on their family. To solve this particular problem, most people purchase life insurance. This simple solution is usually sufficient to address the concern. However, once a person retires and begins to age, they may be more concerned with longevity (living too long) than mortality (dying too soon). If we imagine the future for many investors, we can see how they might live long and healthy lives and simply run out of money.1 However, as investors age, they might face a need for extended custodial care that depletes their assets. Of course, if a married couple has one member with a large pension based on their life (and doesn’t cover the surviving spouse), they may still face significant mortality risk.
It is tempting to believe that financial market risks affect all investors equally. However, this is not the case. The sequence in which a long-term investor experiences returns does not affect their ending portfolio balances. (This assumes that they remain invested and does not account for continuing contributions.) However, an investor withdrawing money can be very significantly affected by the order in which returns occur. This lack of preparation would have affected considerably investors who had not addressed this risk in 2000. For example, let’s imagine a 65-year-old investor who began retirement with $1,000,000 in January 2000 and wanted to withdraw $40,000 annually. They also would like to increase the adjustment by 2% to account for inflation. If that money had been invested in the S&P 500 they would have only had $524,757 three years into their retirement. While markets did recover somewhat, this investor would have reached age 84 with $567,000 invested. If we simply allowed an investor to experience the same returns, but in reverse order, the investor’s ending balance would have been slightly greater than $2,000,000.
Event risk is common to both retirees and people in their working years. Event risk is an unforeseen, non-recurring event that results in a cash outflow. For many people, this would be a significant house repair or buying a new car. While the risk can affect both workers and retirees, retirees’ financial impact and planning need to be different. The difference in effect is caused by the retiree needing to fund the event from their investment portfolio. The appropriate investment portfolio should be constructed to account for unforeseen liquidity requirements.
Finally, the benefits of tax location (investing certain assets in certain accounts) have been widely documented.⁴ However, once a person begins receiving income, they are withdrawing money from those same accounts. Withdrawals from certain accounts are taxed at different rates than withdrawals from other accounts. Also, distributions from certain accounts are considered income. These distributions may cause your income to increase to the point that it affects your Social Security or Medicare benefits.
If you find yourself facing these problems alone, then maybe it’s time to reach out to a financial professional to walk you through a Retirement Check-Up.