Retirement Planning: Managing the Biggest Risk
If you are near or in retirement, there are several risks that can derail your retirement plans. These risks all need to be addressed in some way and some are easier to manage than others.
Most financial planners would agree that the three main financial risks to any retirement plan are:
• Investment risk,
• Inflation risk,
• Longevity risk.
As I wrote in my last post, investment risk can be managed by retirees selecting the proper equity allocation and periodically re-balancing their portfolio. Inflation risk can be mitigated somewhat by owning inflation-adjusted bonds and equities that pay growing dividends. But in my opinion, the most difficult retirement risk for retirees to address is longevity risk.
Fortunately, retirees are not entirely on their own in addressing longevity risk as most retirees will qualify for social security benefits. Social security checks are not affected by any financial markets, are increased each year with inflation (although it does not fully offset all inflation), and will last for as long as the retiree lives. So, these government provided benefits are a good way to manage all three of the above listed financial risks.
Dena at Sunset off Lubbers Quarters
However, for most people social security only covers about 50% (and often less) of their retirement living expenses. If the retiree does not have an employer provided pension, then the other 50% of living expenses must be covered from the retiree’s financial portfolio accumulated while working. Let’s look at an example:
A couple beginning retirement, both 62 years old, needs $60,000 per year to live comfortably. Their combined social security benefits are $35,000 per year. This couple needs to fund another $25,000 income per year from their portfolio. Using the 4% rule for a safe withdrawal rate, this couple needs a portfolio of about $625,000 (Note: the 4% rule allows for 4% to be withdrawn from the portfolio in year one. Thereafter, future withdrawals are increased by inflation regardless of the portfolio performance. The 4% withdrawal rule, historically, can fund 30 years of inflation-adjusted withdrawals about 90% of the time).
In the example above, assuming the couple has been able to accumulate $625,000, they have a good chance of being able to fund their retirement life span, but it is not guaranteed. What if the markets experience a very long bear market which could significantly reduce the longevity of their portfolio? What if one or both people live several years beyond age 92? It is possible this couple, in their mid-90s, could be caught living on just their social security check(s) and dependent on their children or charity. What can this couple do to mitigate these risks?
There is no Place like the Bahamas
There is a solution. That solution is buying an income annuity from an insurance company.
When I was younger and saving for retirement, longevity risk was not something I even thought about. Even when we retired eight years ago, buying an annuity to manage longevity risk was still something I never considered. But in the past few years, I have met many people who are still living in their 90s (and many of them living well).
There is also another consideration specific to our situation. I personally do all our financial planning as well as manage our investment portfolio. I do not use a professional planner or investment advisor. My wife does not get involved in these activities. What happens if I pass away first (a likely scenario)? Or, even if I am around, what if my cognitive abilities decline and I can no longer manage our financial affairs. It is certainly possible to hire a financial advisor at a later date, but I would prefer to have our financial affairs in place and simple enough that my wife will not have to make any big financial decisions. After considering all these things, I started to look at the idea of purchasing an annuity more closely.
Wildlife in the Abacos
The first thing I did was create a detailed spreadsheet model. This model incorporated our annual living expenses (assuming a separate inflation rate for health care and general living expenses) and assumptions about future stock and bond market returns. The model also included our expected income from future social security benefits, rental property, and the required portfolio withdrawals. I laid out several different scenarios varying assumed market returns, inflation rates, and different social security start dates. What I wanted to know from each scenario was how many years would our portfolio last.
The results of the model revealed that, due to the decrease in interest rates of the last decade, “inflation adjusted” annuity-type income has become much more valuable. Those retirees who have inflation adjusted employer pensions, as well as social security benefits are extremely fortunate. These individuals can likely fund their basic living expenses from just these two sources of income. If this is your situation, an insurance company annuity is not needed.
Hopetown Harbour; our winter home
For my wife and I, the analysis of the different scenarios made one thing very clear. If one of us lives into our mid-90s, we could easily exhaust our portfolio. Further, if the markets have a particularly bad decade of returns in the 2020s (in my opinion, given today’s inflated market valuations, not a trivial possibility), we could exhaust our portfolio before either of us reach age 90. So, the first thing my analysis made clear was, to extend our portfolio life, I need to wait until age 70 to start collecting social security benefits.
When to collect social security is a personal decision, because every couple’s financial situation is different. But, for most people, the cheapest way to increase your inflation adjusted annuity-type income is to delay collecting social security for as long as possible. This is due to the fact that the actuarial data that the social security benefits are based on is from the 1970s when average life expectancies were shorter. This makes the average monthly social security benefit more generous than today’s insurance company annuity rates.
Even after delaying my social security start date, the model results, using the worst-case model assumptions, indicated that the chance we exhaust our portfolio before I reach age 90 was not low enough for my comfort level. Therefore, I decided we should consider purchasing an income annuity from an insurance company.
In my next post I will discuss the type of annuity we chose and how we determined the purchase amount.
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