Retirement Risks: It All Starts With Longevity
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With retirement, one sometimes sees the terms accumulation and decumlation. The accumulation phase is the pre-retirement period when we work and save for retirement. Upon retiring, decumulation begins. We need to determine the best way to spend down our assets and obtain lifelong income. When saving for retirement, the focus tends to be on asset growth and total returns. But after retiring the goal becomes to maintain a standard of living.
The transition to retirement fundamentally changes the nature of risk. There are a variety of ways in which we could build a taxonomy for these risks. As the primary financial objective in retirement is to maintain a suitable standard of living for the reminder of one’s life, one basic approach could be to treat longevity as the fundamental risk facing retirees. Retirees do not know how long their retirement will last, and so they face a delicate tradeoff between wanting to spend as much as possible without overdoing it and triggering old age poverty.
As illustrated, longevity risk becomes the overarching risk, because the longer a retirement lasts, the greater are the chances that other forms of risk will manifest. Increased longevity means more time for another financial crisis, more time for inflation to compound, increased chances for an expensive health problem, etc. In this particular taxonomy, remaining retirement risks are broken into three general categories falling under longevity.
First, macro/market risks identify the exposure of a retirement plan to macroeconomic forces beyond a retiree’s control. These risks include investment volatility related to poor market returns and disadvantageous fluctuations in interest rates. Public policy is also a concern, as unexpected increases in taxes, reduced Social Security benefits, or increased Medicare costs can all serve to increase pressures on a spending plan. Finally, sequence or returns risk is included in this category. This is a macroeconomic risk with a more personalized impact, as retirees attempting to fund a constant spending stream from a portfolio of volatile assets are particularly vulnerable to the specific sequence of market returns experienced in the early part of their retirement. It is not just the average return which matters, but also the order of the returns. Poor returns early in retirement will lead to an increased spending rate from the portfolio of remaining assets, digging a hole for the retiree which will be increasingly difficult to overcome even if markets enjoy a subsequent boom.
A second category of risk for retirees is inflation. This is also a macroeconomic risk, but perhaps it deserves its own category as retirees may not realize the full extent of their exposure to inflation. For retirees living on a fixed income, rising prices will slowly erode purchasing power. Things will get more expensive. Even if inflation averages about 3% per year, the cost-of-living doubles in just 23 years. In other words, a fixed income will buy half of what it could at the start of retirement. A lot of retirements will last longer than this. Another concern is that the cost-of-living for retirees may rise faster than the general population, especially as increasingly costly health care makes up a larger portion of a retirement budget .
The third category relates to personal spending risks. These risks are essentially that the basic budget one has prepared for retirement will not adequately reflect actual costs. Issues here include unexpected health care and long-term care expenses, the need to support other family members such as adult children or grandchildren, or divorce. The death of a spouse is also a relevant consideration, as Social Security benefits will decrease by a third to a half, taxes will increase as there are fewer exemptions, and the surviving spouse may be less knowledgeable about the intricacies of the retirement plan. Fraud and theft are growing concerns for retirees as well, as a real issue we face are reduced cognitive abilities as we age and a number of predators will seek to exploit this.
Retirement risks could be classified in other ways. Another worthwhile approach is to distinguish risks based on whether they jeopardize the asset side of the household balance sheet, or the liability side (future spending needs) of the balance sheet. Another division could be whether the risks impact society at a macroeconomic level, or whether they are individual specific. I will provide a link through my personal blog which will consider this alternative taxonomy in greater depth.