A Summary of the Risks Facing Retirees

by Mark Hebner and IFA Contributors - Thursday, 14 November, 2013

A Summary of the Risks Facing Retirees

While for some people it is a happy time of celebration, for others, handling the transition into retirement can be one of the most difficult of life’s many challenges. Retirees face unique risks that require careful consideration. We will expound upon these risks below.

1)      Inflation Risk—the loss of purchasing power over time. As Moshe Milevsky, a professor at York University and one of the world's foremost authorities on retirement planning, points out, every person has his or her own unique inflation rate that is determined by the basket of goods and services they purchase. For senior citizens, this basket tends to be heavily laden with health care-related costs which historically have risen faster than the general rate of inflation. The insidious effects of inflation are especially felt over long periods of time; for example, a 3% rate of inflation over a 24-year period of time results in a 50% drop in the purchasing power of a dollar. For retirees who can no longer rely on their human capital, inflation is a very important consideration. There is some help, however, in the form of CPI increases in Social Security, and retirees who can wait until age 70 to collect their Social Security will earn about 8% for each year of postponement. Furthermore, some retirees may be blessed with a pension that increases with inflation. One way that inflation risk may be addressed is with an immediate annuity whose payments increase with CPI. Furthermore, having an exposure to equities also provides a long-term hedge against inflation.

2)      Longevity Risk—the risk of outliving one’s assets is normally at the forefront of the retiree’s thoughts. With steady improvements in life expectancy, this risk has gained importance over the years. Needless to say, longer life spans also imply an increased exposure to inflation risk, and the last year or two of life can be particularly expensive due to health care costs. An additional risk associated with longevity is the potential decline in cognitive ability which can lead to sub-optimal or even catastrophic investment decisions. A healthy retiree who is particularly concerned about longevity risk may want to consider an immediate annuity through which he will gain a mortality credit (i.e., he is likely to receive a higher yield than he would receive from a low-risk fixed income investment). One  downside of this approach is the exposure to default risk should the insurance company that underwrote the annuity fail, but this risk is somewhat mitigated because  every state has a solvency guarantee fund that  will pay the claims of insolvent companies up to a limit. Furthermore, we now know that the federal government may step in to prevent the failure of a large insurance company such as AIG. Another downside of immediate annuities is that the proceeds used to purchase the annuity irrevocably remain with the insurance company and thus are no longer available to the retiree’s heirs. An exception to this situation is the specification of a period certain such as ten years which will come at the cost of a lower payout. Immediate annuities also offer a great deal of flexibility for married couples; they can be structured to continue with either full or partial payments upon the death of one spouse.

3)      Sequence of Returns Risk—the risk of experiencing low (or negative) returns in the early years of retirement. All too often, people who are near or starting retirement fail to consider the devastating impact of a few years of poor returns on their portfolios. To illustrate, suppose that a retiree planned to withdraw 5% of today’s value of his portfolio in exactly one year from now. Further suppose that the portfolio lost 30% of its value during the year. This means that instead of withdrawing 5% of the value, he would be withdrawing 7.1%, which is not a sustainable number over a long period of time. Young investors who are in the accumulation phase also face a sequence of returns risk, but it is exactly the opposite of the risk faced by retirees. For most retirees, the sequence of returns risk imposes a limit on how much risk they should take in their investments.

4)      Catastrophic Health Care Related Costs—although most retirees are covered by Medicare or private health insurance, the costs associated with a slow-acting disease such as Alzheimer’s can be financially devastating. Two ways that this risk can be mitigated are long term care insurance and a life insurance policy that includes a rider for an accelerated payout of benefits in the event of a critical illness.

5)      Loss of Mental Ability—closely related to catastrophic illness risk is the onset of dementia which can lead to catastrophic financial decisions. All too often, we hear about investment scams that target the elderly. There is little doubt that the same elderly person who got caught up in one would have simply hung up the phone if he had received that boiler room call twenty years earlier. This risk can be addressed by giving a power of attorney to someone who is completely trustworthy.

By no means do we claim that the above list is exhaustive. Our purpose here was to address the primary risks that can have a significant financial impact. If you or a member of your family is either in retirement or about to retire, and you would like to learn more about planning for the contingencies of retirement from an IFA wealth advisor, please give us a call at 888-643-3133.