Retirement has changed dramatically over the past few decades. People are retiring earlier, living longer and staying healthier than ever before. At the same time, Social Security and traditional defined benefit pension plans are predicted to play a considerable smaller role in providing retirement income in the future. These things combined with several other challenges in planning for retirement can add up to a retirement crisis for many individuals. Today we’re going to talk about what many of the retirement challenges are and how you may be able to deal with some of them.
Challenges to Retirement Planning
The Savings Challenge
Over the past two decades, we’ve embarked on what is essentially a novel experiment, replacing the pension plans of the past with a patchwork of individual accounts. We had sound reasons for this: Letting people choose how much they save for retirement instead of counting on their employers to give them a decent pension if they put in enough time makes sense. But if the basic idea of personal responsibility for retirement is appealing to most, the reality is a lot thornier. They need to make their own decisions on how much to save each month, how to allocate savings, and how to take disbursements in retirement. This is a dramatic change from their parents’ generation, who relied heavily on defined-benefit pension plans, which guaranteed them income for life once they retired.
The sad reality is that most Americans aren’t saving enough for retirement. The U.S. savings rate has been generally falling for more than 20 years. Because of virtually unlimited access to credit, many people find a way to spend beyond their means, regardless of how much money they make.
A good goal to shoot for in saving for retirement is 15% of your earnings….for your entire working life…very few people do this. Many financial advisors believe their clients can safely withdraw between 4%-5% each year from their portfolios in retirement. At a 4% withdrawal rate, you would need 1 million saved to draw $40,000 a year from it. In order to save that much money, you will need to start early!
The Longevity Challenge
What is the longevity challenge? Simply put, it is the risk that you will outlive your assets. Longevity risk is perhaps the single biggest risk facing retirees. That said, life expectancy plays a critical role when planning for retirement. Many people underestimate their life span and risk outliving their assets. For example, for a couple aged 65 there is a 50% chance one partner will be alive at age 92, and a 1-in-4 chance one will be alive at age 97. Many of your retirement decisions, such as when to retire, how much money to take from your portfolios each year, and how to invest your assets, will flow from this longevity decision. It’s great to be able to live a long and healthy life, but you’ll need to plan carefully to make sure your money lasts as long as you do. Many professionals will suggest that you plan for your retirement assets to last for 30-40 years.
The Inflation Challenge
Most consumers don’t understand how inflation can damage purchasing power over long periods of time. One dollar today simply doesn’t buy as much as it did in 1970, and it will buy even less 30 years from now.
Inflation has averaged about 3% annually since 1926. Three percent may not seem like much, but it can significantly erode your purchasing power over long time horizons. Take for example the impact a 3% inflation rate can have on a fixed annual income of $100,000 over a typical 30-year retirement. In 30 years, the purchasing power of your income would be reduced by nearly 60% to $40,101.
An also important point is that there is a good chance that the rate of inflation you will experience in retirement will exceed the long-term 3% average, simply because the goods and services that you will be purchasing won’t resemble what the typical consumer is buying. Medical expenses in particular are likely to be a significantly higher portion of your overall spending. Which, leads into our next challenge:
The Healthcare Challenge
Rising health care costs coupled with inadequate health care coverage can have a devastating impact on a retirement. In the past, Medicare provided all the medical insurance coverage necessary for retirees. Today, as retirees are living longer and striving for healthier lifestyles, Medicare may fall short in meeting your needs. Most people are aware that the Social Security system is under extreme stress, but many experts believe that the solvency risk of Medicare is even more severe. While both programs face similar demographic challenges, Medicare is also impacted by the rate of health-care inflation, which recently has run about 2% higher than the overall rate of inflation over the past 20 years. As with Social Security, Medicare will require some combination of higher taxes and lower benefits to resolve the issue.
In addition to typical medical expenses in retirement, you should also consider the cost of long-term care arrangements should you need professional care in your later years. Currently in the US, the cost for a semi-private room in a nursing home costs an average of $89,297 a year and a private room costs an average of $100,375. In most cases, long-term care health insurance coverage provides benefits for nursing homes, assisted living facilities, and home care. If you can afford the premiums, you may want to consider purchasing long-term care insurance.
The Asset Allocation Challenge
Despite the risk inflation can pose to retirement savings, the natural tendency for many retirees is to protect their investment assets by investing conservatively. As a result, many retirees’ portfolios are largely allocated to bonds and cash with minimal exposure to stocks. History shows, however, that of these three asset classes, stocks were the only one to provide significant growth after accounting for inflation.
A long-term horizon can cushion the impact of short-term volatility and extra risk associated with stocks. The payoff for accepting this extra risk is a portfolio that has a better chance of keeping pace with inflation and protecting your purchasing power. Given this, you should consider some exposure to stocks. Conversely, being overly aggressive in retirement can increase the potential for portfolio losses.
Asset allocation/diversification is part art and part science and very often requires the help of a professional. Someone that can look at your circumstances and time frame and find the best mix of equities/stocks and fixed income/bonds to best reach your goals.
The Withdrawal Challenge
The first question many retirees ask is how much money they can safely extract from their portfolio each year. A simplistic way of looking at this is a withdrawal rate, expressed as a percentage of your investment assets. Historically, withdrawal rates that could support an investor over a 30-year retirement have varied from 4.25% to 5.95%, depending on the asset allocation of the portfolio. Many optimistic investors hope to withdraw 10% of their portfolio annually, while more conservative investors only withdraw interest and dividends. Unfortunately, there is no magical formula or simple solution. The optimal withdrawal rate will vary from investor to investor, and may vary over time.
Market returns affect how long your retirement portfolio can sustain your desired withdrawals. When poor returns occur early in retirement, the risk that your portfolio will run out of money during retirement dramatically increases. Financial planners call this “point in time” risk. Many financial planners suggest that you adjust your withdrawal rate and spending each year based on the returns you earned in the previous year. If you face poor returns early in retirement, you might want to lower your withdrawal amounts for a while. Conversely, in years when you earn good returns, you can maintain, or perhaps increase your withdrawal amounts.
Retirement risks such as longer life expectancies, inflation, withdrawal rates, and unfortunate timing can create an unpredictable retirement scenario. Preparing for your future begins with an understanding of these challenges and the amount of income that might be available to you going forward. Though many people believe they have adequate resources for retirement, few actually do. Be proactive and establish a foundation for retirement using reasonable expectations and adjust periodically to boost your chances of enjoying those golden years.
Helping people prepare for retirement is one of our specialties. We have software that considers all the challenges when running retirement projections so you can feel more confident in your plan. Each plan is tailored to your unique needs, situation, and goals. Contact us today if you’d like us to help in your retirement planning. You can schedule a call or meeting by clicking on the link below.