Retirement is a strange transition for many people. We are no longer using a paycheck to pay our bills. We are now relying on a mixture of fixed income and investment income to get us through the rest of our lives.
Because of these changes, the types of risk that we are exposed to in retirement are different from what we are used to.
Here are some of the biggest risks that we have to deal with in retirement.
Public Policy Risk (AKA, the rules changing risk)
The strategies that we use to get good financial results are often directly tied to the laws that the government has set up. For example, there are a number of tax advantages for investing in an IRA or 401(k) so it makes a lot of sense to do so.
But, for whatever reason, if the tax laws were to change, it may not make as much sense to use these accounts to save for retirement.
There are a number of ways that law-changes could affect your retirement. Here are a few:
-Increased taxes
-Decreased Social Security or Medicare benefits
-Lowered age for Required Minimum Distributions (RMD’s)
Order of Returns Risk
Oftentimes, when we look at how Investments are performing, we look at their average return over time. But unfortunately, this is not the only thing that matters. The order of returns starts to matter a lot in retirement because you are withdrawing money every year to pay your bills.
And when I say “order of returns”, I am referring to when the market goes up and down. The market may average about 10% growth every year but if the market has a long sequence of bad years at the beginning of your retirement, it is much easier to run out of money even if the market recovers fully later.
For example, let’s say you have $100 and the market fell by 10% this year. This means that you now have $90. You now need $10 of it to live off of so you are now left with $80. Next year the market goes up by 10% which means you end up with $88.
Now let’s change one small detail from the above example. Let’s say that the market went up by 10% the first year and down by 10% the second year instead of the other way around.
This means that your account would grow to $110 with the market and you’d take out the $10 you need to live which leaves you with $100. The market now goes down by 10% and you are left with $90. This is $2 more dollars than the first example by only changing when the market went up and down.
And while $2 may not seem like enough to worry about, as the amounts get larger and returns have years to compound, the difference can become substantial overtime.
Interest Rate Risk
We all love getting really low rates on our mortgages but low interest rates aren’t good for everything. When interest rates are down, bonds (which are especially important for retirees’ portfolios) tend to perform poorly as well.
For example, with interest rates as low as they are, the short-term bonds are only returning 1%-3% which is barely outpacing inflation.
Also, as interest rates rise, it tends to lower the value of the bonds that are already in the market because the newer bonds are being issued at higher rates.
Conclusion
There are a number of strategies that can be used to lower our exposure to these risks but it will depend widely based on your situation.
One of the ways to account for these risks is by simply having some wiggle room in your retirement plan. If you are planning to barely skim by and have just enough based on the current circumstances, you may find yourself in trouble if things change. It is always wise to have some margin when we calculate our retirement numbers to make sure that even if things do change we will still be okay.