Four Risks to Consider When Preparing for Financial Independence
“Retirement” seems to have a much different connotation than “financial independence” within the world of personal finance. In my opinion, a true “retirement” seems a long ways off, however, the goal of ”financial independence” seems to be within reach for most (especially the frugal among us) - but even after all of the debt is paid off and savings has been accrued, there are still some things that need to taken into consideration:
Problem: Inflation Risk
Finance 101: a dollar today is always worth more than a dollar in the future. Will your retirement savings be able to earn enough to keep up with inflation?
Hedge against this risk:
Because the market historically returns an average of 10%, it’s best to have at least little market exposure in your retirement portfolio. I like index funds - which leads me to the next risk:
Problem: Market Risk
I like index funds to deversify market risk, but there are times (like right now), when the market is generally down. Some 401(k) portfolios have lost 10% or more in the last several months, leaving pre-retirees feeling a bit discouraged.
Hedge against this risk:
One could move all of their retirement savings out of the market and into guaranteed investments like CDs, but that really limits the ability to offset inflation risk. Some try to time their withdrawals with the market - but what is one to do if their desired retirement age coincides with an extended period of “economic downturn”? My recommendation: invest in a mix of target date funds and bonds to keep your portfolio working for you.
Problem: Longevity & Health Risks
Some financial advisors address these seperately, but they are actually two heads of the same monster. There’s a good chance that either you or your partner could live well into your 90’s. If you retire in your sixties, do you have enough saved to live comfortably for another 30 years, even in the face of catastrophic illness?
The sad truth is that more retirees are easily outliving their retirement savings.
Hedge agaist these risks:
The only real solution for outliving income is to die sooner or have a guaranteed lifetime annuity that gives you a monthly ‘pay check’ for life. But even if you go this route, you may not be doing enough to mitigate the medical expenses commonly associated with aging. Alzheimer’s, dementia, or chronic illness can quickly deplete the savings of even the most well-preprepared investors. Long term care insurance is a reliable hedge against this risk, but is also extremely expensive.
Problem: Withdrawal Rate Risk
This is the biggest risk that nobody talks about, and it’s tied into market risk and inflation as previously explained.
Do you know what percentage of your nest egg can be withdrawn each year to sustain you through retirement?
Hedge against this risk:
Advisors used to recommend 7 or 8% withdrawal rates for retirees in their 60’s, but the new prevailing wisdom tells us that a 4% withdrawal rate may be more realistic.
No single solution addresses all retirement risks, so most financial advisors and agents recommend a blend of bank, fund, bond, and annuity solutions to maximize retirement income. Talk to your advisor or banker about portfolio allocations in retirement and distribution strategies to make the most of your retirement savings.
Stumble it!
June 6th, 2008 at 7:25 pm
Dear Banker Girl:
Right on!
Sometimes there is the perfect storm - stock portfolios stagnate (or decline), fixed income portfolios yield little, and inflation increases - leaving a negative real return on the fixed income portfolios. That is when the withdrawal risk skyrockets and can sink a well thought out retirement plan.
At such times, immediate annuities become less attractive.
In our working years, declining stock portfolios meant our stock buying power increased - we just kept investing and buying more shares. In the retirement years, we don’t have the same volume of dollars to buy those value stocks.
You hit the target with the blend approach.
One way to mitigate these retirement risks is to modify the behavior that we had while working (buy as stocks ticked down or up) and do the same in retirement.
That means taking the profits gradually on the up cycles and buying on the down cycles. (I don’t mean at the top and then the bottom - who knows? But we can tell up cycles and we certainly know down cycles.)
For me, that means moving about 5 years’ expenses into a “cash” reserve. Keep moving a little into that reserve when stocks are ticking up, and fixed income is so-so into a “cash” reserve.
Yep. The return is low. The liquidity is high. The sleep is terrific. And, eventually, during down cycles, there is the opportunity to move some of the liquidity back into stocks.
OR, if interest rates move up (higher than your expected long term inflation guess), gradually buy immediate annuities.
One mistake that I think some retired people make is to buy immediate annuities as if it is a one shot deal. I think gradual buys can provide a better return. (Unless I have perfect knowledge about where the top of a interest rate cycle is.)
Another way to mitigate the withdrawal risk, for me, is to postpone taking social security. I have not been able to buy an immediate guaranteed fixed income annuity that beats my social security benefits’ *growth*. (TIAA-CREF has come close in some cycles.) Sure, when I die my heirs receive nothing (well my surviving spouse gets my benefit). For us, this is about my wife and me, not our heirs.
For me, social security benefits sit until age 70 is a terrific way to keep building an annuity at rates that beat the market right now. As long as social security benefits are indexed to inflation, it is almost impossible for me to buy an immediate annuity for a similar amount.
One other area to mitigate risk for me is the income tax. I think that if I gradually move assets from my traditional IRA to Roth - managing the tax to the low brackets, then when I am 72.5 and have to take minimum required distributions from the money remaining in the traditional IRA, I won’t have as large a tax to pay on the social security benefits that makes economic sense to start at age 70.
So, maybe another retirement risk is the income tax risk.
Best wishes for continues perseverance and success with your blog.
Joe
June 9th, 2008 at 9:10 am
My plan for market risk and withdrawal rate risk is to take out the same percentage every year. (The usual advice is to calculate that percentage the first year, and then increase the withdrawal amount each year to keep up with inflation, no matter what’s going on with your investments.)
My method means your income goes up and down each year as your investments rise and fall, but you never run out of money.
In the years where you withdraw more than you need, invest the excess in an emergency fund. In the years where you withdraw less than you need, get the rest from your emergency fund.
Finally, don’t withdraw equally from all parts of your portfolio each month. Withdraw from the ones that are doing well compared to what is expected for that investment class.
I really like Joe’s perspective on Social Security. But I’ve always felt that Social Security was riskier than stocks and bonds, so I’ve always thought I would withdraw money at the first possible date and then invest it. But depending on the ratios of where your money is coming from and how your investments are doing at the time when you can first withdraw the money, keeping it in Social Security as long as possible might really improve your diversification and thus reduce your risk.
I’ll have to think about that. Maybe I’ll change my strategy to taking Social Security the first date that my investments are lower than I expect, so I can use the first paychecks, at least, to invest cheaply.
January 25th, 2012 at 2:59 am
“bound and gagged
Spouse to a BDSM Lifestyler Keep These Aspects in Mind:”