ARTICLES & REVIEWS
The Five Key Risks to Retirement Income
London Free Press
With the price collapse we witnessed in 2008, it is not clear if pre and post retirees are prepared for the financial risks they will face going forward. Research conducted by The Strategic Counsel and sponsored by Fidelity Investments found only 29% of retirees have a written financial retirement plan. Even those that do have a plan often fail to understand the basic risks and key issues, the 5 key risks that need to be examined are:
- LONGEVITY RISK
During the 20th century average life spans increased dramatically, as a result it is quite possible that people retiring today may live another 20, 30 or even 40 years. Without planning a longer than expected life expectancy, retirees could easily outlive their savings.
A man who has reached the age of 65 has a 50% chance of living until the age of 83 and a 1 in 4 chance of living until the age of 89. A 65-year-old woman has a 50% chance of living to 86 and a 1 in 4 chance of living until the age of 92. The odds are that at least one member of a 65 year old couple will have a 50% chance to live until the age of 90 and a 1 in 4 chance that one member of that couple will live to the age of 94. That is a long time and could require a lot of funding.
- INFLATION RISK
In the last half of the 20th century, inflation eroded Canadians purchasing power by about 90%, reducing a 1950-dollar to twelve cents today. In recent years inflation has been relatively low, but even in the 1990’s overall cost rose more than 20%. Inflation in other words is constant and retirees need to plan for it. Even at a modest rate of inflation, retirees with $46,000 worth of living expenses today would see their purchasing power eroded by roughly 39% at 2% inflation in 25 years and 55% erosion at 3% inflation over 25 years.
- ASSET ALLOCATION RISK
In retirement, asset allocation becomes more subtle balancing act, on one hand investors need to take a different approach to equities as they cannot afford to wait for their investments to recover from market dips. In many cases they need the income now but they also need to ensure that their investments will last as long as they do and keep up with inflation. So even in retirement most investors will probably do best with a global balanced portfolio. With a 5% withdrawal rate from a conservative portfolio during an extended down market the life of a portfolio could be projected to be 20 years. With a more aggressive portfolio, the life of the portfolio would reduce to 17 years. As you can see aggressive and withdrawal can result in investment failure. This may be a time to re-examine Term Certain Annuities and Life Annuities along with Guaranteed Withdrawal Plans. Product Allocation will become a new solution to Portfolio exhaustion.
- EXCESS WITHDRAWAL RISK
How much retirees withdraw will dramatically effect how long a portfolio will last. Until recently, many people assumed that they could draw 7% or 8% per year because of high equity returns between 1982 and 2000. In fact retirees should plan on more conservative rates adjusted upwards each year for inflation. This will improve the chances that their portfolio will provide income for the rest of their life. For example a 65 year old couple that retired in 1972 with $500,000 which is allocated 50% to stocks, 35% to bonds and 15% to short term investments would have experienced a zero balance in their portfolio in 1990 if they withdrew 6% of the principal plus inflation each year. But with a 4% withdrawal plus inflation the portfolio would have provided financial security for both spouses for the rest of their lives. A withdrawal of 2% per year meant the difference between financial independence and financial disaster.
5. HEALTHCARE EXPENSES RISK
Healthcare spending has been rising in recent years and private spending has grown to about 30% of the total healthcare expenditure. Some experts believe that individuals may have to bare more of the burden of healthcare expenses in the future. Those preparing for retirement need to understand what is covered and what is not. The 2005 IPSOS-REID Survey that 49% of Canadians do not have a financial plan to deal with a critical illness (either their own or that of a family member). Close to half of retirees now turning age 65 will be admitted to long-term care facilities at some point in their lives. Nearly 25% will stay there for a year or more and almost 1 in 10 will stay 5 years or more. Since the government only pays only a portion of these costs this can be a major expense. Think about having more certainty of services that are available through government plans, for example: more nursing or rehabilitative care in order to stay home. Think about having access to different services than those available through government plans, for example: drugs that are approved for sale in Canada but not available through the government drug benefits program.
Financial security in retirement depends on understanding and managing a series of risks that can erode even significant life savings. How one should invest when making withdrawals from their portfolios can be in total opposition to how one should invest when building their portfolios. Knowledge of these risks can help you make the right choices for a more secure retirement.
