Every retiree faces the same risks when it comes to taking income from their investments and savings.
- Investment/Market risk
- Withdrawal Rate Risk
- Sequence of Return Risk
- Inflation Risk
- Deflation Risk
- Longevity Risk
We better take a look at each of the risks and how they can impact you.
This is pretty simple. If you have your money invested and at risk, you can suffer significant, and even catastrophic losses due to market drops.
The theory is the closer you get to retirement the less risky you should be. One broad concept uses an age-old formula.
If you take 100 and minus your age, this is the percentage of assets you could have at risk.
If I was 70 years old, then having no more than 30% at risk is the rule of thumb
(100 – my age, 70 =30).
However, this is extremely broad. I find more and more people who are becoming risk-averse and may want much more of their assets safe and secure. Even taking a risk with 30% of their assets for some may be way too aggressive.
There is what I call the “gut factor.” How much can you afford to lose to market swings and at what point does your gut say, “That’s enough?” You have to honestly ask yourself, “What if I lost all this money, how will it affect my future income needs?”
Just because a neighbor or coworker is at risk, does not mean you have to be. Never take more risk than you are comfortable with. That is the best rule of thumb.
Withdrawal Rate Risk:
This risk relates to taking out too much money and running out of money before you run out of life.
How much can one withdrawal each year and make sure they won’t outlive their money?
There are several variables here, of course, one simply being investment risk and if there are losses incurred.
The other being how much you take each year.
Back in the 80’s and 90’s it wasn’t uncommon for advisors to tell their clients they could comfortably take out 10% per year and their money should last and even grow in their retirement years.
Returns and even risk were much different than they are today.
You may hear advisors say 6% or 7% nowadays, but no one will tell you 10% is a safe withdrawal rate and if they do…RUN!
Side Note: There are investments that have very nice income opportunities. One that comes to mind is a paid-up whole life policy. If you are no longer adding new premiums and you have a paid-up policy, you can get dividends ranging from 5%-7% (currently) and still keep your principal (cash value) intact. However, you have to plan for this and start as early in life as you can and typically have 8-10 years to fund.
The Wall Street Journal did a study on the “Bullet Proof Withdrawal Rate.” You know what they found? The bulletproof withdrawal rate that would last throughout your lifetime was 2%. 2%… can you believe that? Based on interest rates and where this market has been, I can see why.
They went on to say that you could probably get away with 3%, but anything above 4% had a high probability of not lasting.
Withdrawal rate risk is taking out too much money each year, particularly in the first years. Calculating your withdrawal rate and projecting how long your money will last at that withdrawal rate would be a good idea.
Let me share with you’re the results of a Met Life survey:
Almost seven in ten (69%) respondents overestimate how much they can draw down from their retirement savings—with 43% saying they believe that they can withdraw 10% or more while preserving their principal—even though most experts suggest a withdrawal rate of no more than 4% annually.
Over half (56%) of pre-retirees are now aware that longevity risk, the risk of outliving their retirement savings, represents the most important financial risk facing them in retirement. Despite significant improvement over 2003, the results suggest there remains a lack of understanding in applying that knowledge. For example, six in ten (60%) respondents underestimate their chances of living beyond a given average life expectancy. The rate at which pre-retirees identified they would withdraw from their retirement savings suggests that today’s longer life expectancy is not being fully considered in their retirement calculations.
The simulation used in this example assumes the following: the dollar amount of withdrawals are then increased at a rate of 3% per year to account for inflation (historical average from 1926 – 2006 is 3.07%); the behavior of the hypothetical asset portfolio is based on historical data from Ibbotson Associates: Stock analysis is based on the S&P 500 Composite index. The bond analysis is based on a US Long-Term Corporate Bond index. We used 5,000 scenarios based on historical averages within the period from 1926 to 2006 to determine how a portfolio might have performed. We reduced the annual performance of the stocks by 1.09%, which we believe is a reasonable assumption for the average fund expenses for equity mutual funds. We reduced the annual performance of the bonds by 0.72%, which we believe is a reasonable assumption for the average fund expenses for bond mutual funds. This may not be used to predict or project investment performance and does not take into account the effect of taxes.
Think about this for a moment. Suppose you were checking in at the airport and you ask the question, “What are my chances of getting in an airplane crash?”
The statistics are pretty low. You have a 1 in 29.4 million chance of dying.
I know, you are probably saying well who cares about statistics because if you are that 1 person, and I’d agree.
|Airplane Crash Statistics||Data|
|Odds of being killed on a single airline flight||1 in 29.4 million|
So going back to our withdrawal rate of 4%, even at that rate, 10% of those run out of money. You have a 90% chance of making it.
I’ll ask you the same question comparing to an airplane flight. If the captain said you have a 90% chance of making it to your destination, what would you do?
I may not take that flight! That means 10 out of 100 aren’t going to make it.
Moral of the story, the Wall Street Journal was right, somewhere between 2% and 3% is the safe withdrawal rate.
Sequence of Return:
We have an entire video segment regarding Sequence of Return. This may be one of the single most overlooked issues that pre-retirees and retirees are faced with.
Put simply, there is a danger zone, which is about 5-7 years before and 5-7 years after you retire where you simply should not lose money.
If you withdraw money for income and lose money due to markets dropping, it’s a double whammy to your portfolio and you’d be surprised how much faster one can run out of money.
Sequence of Return proves that when you start taking money out for income when suffering losses can be devastating. You could likely be fine if losses came 10 or 15 years after you retire. However, taking losses in those first 5-7 years could wipe out years of income later.
It is well worth your time to understand this particular risk!
This may be self-explanatory to anyone over 40. All we have to do is look back and see what things “used” to cost and we know what inflation is.
Inflation is the cost of living rising. You’ve heard grandma and grandpa talk about gas at 25 cents and how a loaf of bread cost a nickel. Fun to listen to and imagine isn’t it?
I remember when I was a teenager I built houses for a custom homebuilder. This was in the late 70’s.
We were building a very nice custom home in a decent neighborhood. This wasn’t a mansion or too crazy, but it was a nice home by the standards back then.
I’m guessing the home was about 2800 square feet, a mid-sized lot, and nice finishing touches.
This would be a second or third home today, not a starter home.
The cost was $105,000. I remember thinking, what millionaire is buying this beast? I mean I was making $3.50 an hour (more than most of my friends, $2.50 was the going rate) and there was no way I could imagine being able to afford a $100,000 home.
Years ago my daughter bought her first starter home. Much smaller, nothing fancy, and guess what they paid? Over $130,000. That my friend is inflation!
I’m sure all of you have similar stories of your own or those of your parents.
Inflation essentially occurs when there are too many dollars chasing too few goods. There are several areas that seniors need to be concerned about when it comes to inflation. The three most prominent are the price of food, energy, and transportation costs.
The reality is, inflation can eat at one’s income and over time and lose purchasing power.
There are some ways to combat it and should be considered when deciding on taking income from your portfolio.
As you might have guessed deflation is just the opposite of inflation. So why is that a big deal?
We have to understand what causes deflation first.
If inflation were caused when too many dollars chase too few goods, then the opposite would be too many goods and not enough dollars chasing after them.
So why does deflation occur?
The short and easy answer is because of debt.
When we work and get a paycheck and then go spend our money, the money gets involved in the economy, commerce takes place, and we have growth. It’s referred to in the banking world as “velocity of money.” It’s basically how often a dollar is spent, and then spent again, and again.
Over the past decade or two, commerce has come in the form of debt. Instead of saving and then spending our money, we’ve gone out and borrowed money, and hocked our future earnings to pay off the debt…later.
Think of the homes, boats, cars, toys, and everything else that was purchased using borrowed funds over the last 20 plus years.
That sparks the economy’s growth – for a while – as we saw in the 90’s and most of 2000’s.
Our government did this as well, but on a much larger scale and in multiples that you and I can’t even imagine. No bank or credit card company would have ever let us borrow and spend in the same ratios (income to debt ratio) that the government has.
After all the years of spending borrowed funds and going into debt – it’s now time to pay the piper.
Instead of working, saving and spending and buying new goods to help our economy grow, Americans are now working and paying off debt. This does not contribute to the growth of our economy.
The debt that boosted our economy for many years is now the debt that could cause deflation.
There is a greater chance that deflation will occur rather than inflation.
Why are prices going down considered to be a bad thing?
It’s a barometer of the entire economy:
- Lower prices are needed to encourage buyers
- Fewer goods being produced
- Employers laying off their work-force
- Wages being cut
- More unemployment
- Spending down
You get the picture, it’s not good for the economy.
This, in turn, is not good for any of us as most of our money is somehow tied to the economy. Markets drop, interest rates drop, savings drop, and it’s an overall downer for everyone.
Deflation can hurt everyone over time.
I’m going to say something about longevity risk that may not seem right at first, but then I think you’ll agree: Longevity Risk could quite possibly be the Highest Risk of All!
In fact, longevity risk is a RISK MULTIPLIER!
What is this Longevity Risk?
It’s the risk that you are going to live too long – sounds horrible doesn’t it? Now you know why there is so much talk about death panels (snide remark).
There is a very high chance that your life expectancy will increase 2, 5, maybe even 10 or 20 years.
The risk that you will run out of money is extremely high if you plan on dying based on mortality tables today.
I watch planners all the time projecting income out to age 85, maybe 90. What about 95 or even 100? This is a real possibility.
Why do I say Longevity Risk is a Risk Multiplier?
Think about this…
If you retire at age 67 and die at age 69 there likely has not been enough time for any of the other risks to really affect you. I mean……….
- If the market crashes: You’ll probably be fine.
- If interest rates rise: You’ll probably be fine.
- If interest rates drop: You’ll probably be fine.
- If inflation starts to rise: You’ll probably be fine.
- If deflation sets in: You’ll probably be fine.
- If gold has a huge drop in price: You’ll probably be fine.
However, say you live to age 95, add Longevity to any of these risks and it’s MULTIPLIED. Every risk is INCREASED if you have a Long Life Span!
- Market drops are worse
- Inflation is worse
- Interest rates are worse
- Deflation is worse.
You have almost 30 years that your money has to last and give you a paycheck.
This is why now, more than ever, you need to figure out a way to get a guaranteed income for life!
You need your own private pension. You need a paycheck – A paycheck that you can’t outlive!