Getting Ahead of Risks to Your Retirement Plan

In theory, retirement planning should be a straightforward process; you work, earn, save, contribute, and then enjoy the returns as income for the rest of your retirement. It’s exactly this process appearing so simple that ends up being the greatest source of pain for retirees.

There are a number of risks to retirement planning that can reduce the overall value of your portfolio, putting you in a financial bind after all your hard work and sticking to what you thought you should have. 

Lacking the awareness of these risks and a proactive strategy for them can threaten the possibility of a secure, stress-free retirement. That’s why we want to provide insight on what exactly these risks are, why they occur, and better equip you for the retirement you deserve.

Market Risk, Drawdowns & Withdrawals

With a market downturn, many who are planning their retirement don’t realize it’s not something to just get past and recover from. Once you retire and start drawing income instead of contributing, that past downturn becomes a permanent reduction in your future retirement income’s value.

As an example, normally a 35% decline on a $1 million portfolio would be a loss of $350,000. Now factor in an event like the 2008 housing market crash; the peak-to-trough drawdown from before and after wasn't 35%, it was closer to 51%, cutting the value of that same portfolio in half and requiring a roughly 53% gain to actually recover.

It gets worse when you're withdrawing income at the same time the market is falling. Another example: a retiree draws 4% annually, or $40,000, from a $1 million portfolio. If the market drops 20% in year one, the portfolio falls to $800,000, but the $40,000 withdrawal still has to come out. That same dollar withdrawal represents a larger percentage of a smaller pool of money, which accelerates depletion and makes recovery harder.

Sequence of Returns Risk

For a retirement plan to work, it's not just how much your portfolio earns over time that matters, but the timing of when the gains and losses occur. There is actually a name for this, which is ‘sequence of returns risk’.

Two retirees with the exact same long-term average returns can end up in dramatically different positions depending on whether a downturn happened earlier or later in their retirement planning. The retiree who experiences stronger returns in the first five years of retirement and weaker returns later will almost always be better off than one who experiences the opposite. 

Sequence of risk is arguably the most underestimated in retirement income planning, and it can't be fixed after the fact with a smarter withdrawal strategy. Once the damage is done, a full recovery is impossible.

Inflation Risk

While prices rise over time, wages also typically increase over time and your income can also adjust across different positions in your career. In retirement you lose that flexibility, and the spending power of your fixed income decreases over time, even if the dollar amount never changes.

This is inflation risk, and even a seemingly harmless inflation rate of 3% will cut the purchasing power of your dollar in half in just 24 years. To add insult to injury, healthcare costs, including the medications and long-term care that seniors drive a higher demand for, have historically risen at a higher rate than other goods and services.

Retirees who transition entirely into a fixed income arrangement for their retirement find themselves losing ground every single year because their income remains flat while the world around them gets more expensive.

Interest Rate & Renewal Risk

Interest rate and renewal risk affects anyone relying on bonds, CDs, or short-term fixed annuities, because when those mature and get reinvested they're at the mercy of whatever the rates are at the time. Retirees who locked in attractive rates one year found themselves rolling into far lower rates years later and were stuck there for the better part of a decade.

The best way to describe the relationship between interest rate and renewal risk is a ‘rise’ and ‘fall’ respectively:

Interest Rate Risk, the Rise

If you own a 10-year bond paying 3% interest and the Federal Reserve raises rates so that new bonds pay 5%, no investor will buy your 3% bond at face value. In turn, if you sell it you have to discount the price and by selling your bonds early to cover living expenses means you’re forced to lock in a permanent capital loss.

Renewal Risk, the Fall

When fixed-income investments mature, you will be forced to reinvest that principal in a lower-yield environment. If you build a portfolio of CDs or short-term bonds during a high-interest period, they will eventually mature. Your principal remains intact, but your reliable income stream is suddenly cut in half.

Longevity Risk

The most straightforward and underestimated of the bunch, longevity risk is the risk of living longer than your money lasts.

With advancements in healthcare and medicine, and the promotion of healthier lifestyles, seniors are living longer than ever in the past. While that may be good news for personal health, this has some bad implications for financial health in retirement, with a longer span of time for more expenses, rising inflation, exposure to market downturns, etc. In other words, longevity risk is a multiplier effect for every aforementioned risk.

With that comes the biggest overlooked problem, when retirees plan around "average" life expectancies. Logically, there is a 50% chance of outliving the average life expectancy, leaving retirees vulnerable later into their retirement if they do not plan ahead.

Overcome Risks by Overcoming Traditional Thinking

The problems that these risks pose to traditional retirement plans is not a condemnation of them per se, rather a reflection of how times have changed. What once was a reasonable and effective framework has been subjected to increased economic volatility and longer lifespans. The old mindset just doesn’t work anymore; what retirees need nowadays is a paradigm shift.

A useful new way of thinking is making the distinction between ‘red’ vs ‘green’ money and applying the “Rule of 100”. 

• Red Money: represents capital exposed to market risk, stocks, growth funds, anything that can rise or fall significantly in value. 

• Green Money: represents capital protected from market risk, things like fixed income, cash equivalents, and guaranteed products such as annuities.

• The Rule of 100: subtract your age from the number 100, and the remainder is approximately the percentage of your portfolio that should be green money.

The point isn't to keep that exact percentage of green money; the Rule of 100 calls for a thoughtful balance with your portfolio, deliberately protecting principal and guaranteeing income rather than chasing growth with money you can't afford to lose. In fact, taking on some risk can be a good thing if you know what you’re doing and remember to weigh it proportionately with secure assets.

The Key to Avoiding Risk is Balance

The truth is that no single financial product can solve every one of these risks at once. Stocks provide growth but expose you to market and sequence risk. Bonds reduce volatility but introduce interest rate and inflation risk. Cash provides liquidity but guarantees a slow erosion of purchasing power. Trying to rely on one category of assets to generate income while avoiding financial risk for an uncertain number of years is just asking for too much.

An effective retirement portfolio is diversified with both green and red money, and one of the most secure forms of green money are annuities, especially when a laddering strategy is implemented. When you apply the Rule of 100 to ratio laddered annuities and other stable sources of fixed income accordingly, you can optimize the remainder of your portfolio to generate income growth without putting your retirement at risk.

To find out what the best strategy is for your portfolio based on the financial products and income sources available, contact National Annuity Educators for a free consultation.