The latest issue of Money Magazine had an interesting interview with a retirement expert from York University named Moshe Milevsky. In it, he detailed the three biggest risks of retirement. Any guesses as to what they are? Here’s his view:
- Longevity risk
- Inflation risk
- Market risk
What follows is a quick breakdown of each one…
Longevity risk refers to the possibility that you’ll outlive your savings. With retirement lasting anywhere from 10-40 years (perhaps longer depending on how early you retire) this is a very real issue for many retirees, especially now that most people are relying on their 401(k) and IRA funds instead of a monthly pension check. Fear that retirees will outlive their savings is one of the reasons that so-called longevity insurance (which is really just a re-packaged, deferred annuity) has become increasingly popular.
Inflation isn’t so much a risk as an inevitability. When you’re working, your income typically increases to keep pace with inflation. But after retirement, many individuals are living on a more or less fixed income, and inflation becomes a major factor. Consider this… Over a 25 year span, 4% annual inflation will devalue a $1, 000 monthly pension to the equivalent of just $375. Even if you’re not on a fixed income, you still have to manage your money in such a way as to minimize market risk (below) while staving off inflation risk.
When you’re working, down markets aren’t necessarily a big deal. You’re still smack dab in the middle of the accumulation phase and, as long as you buy and hold, you have plenty of time to recover. In fact, as long as things eventually recover, down markets can boost your returns, as you’ll be buying shares on the cheap. That being said, a down market can wreak havoc if it occurs early in your retirement. The reason for this is that, once you hit retirement, you’ll likely start selling assets to generate cash. And when you pull money out during a down market, you effectively lock in that loss making it hard to recover.
Reducing your risks
As with anything, it appears that the key to defusing these risks is to diversify. According to Milevsky, this might include not just an age-appropriate mix of stocks and bonds, but also fixed and variable annuities. Traditional mutual fund investments help protect against inflation risk, whereas fixed annuities protect against longevity risk, and variable annuities promise some of the gains of the overall market while guaranteeing a minimum payout in the face of a bear market.
Note: Just to clarify the last bit about risk reduction… When asked about the fact that his own previous research that showed variable annuities to be overpriced, Milevsky responded:
If today’s variable annuities looked like the product of the same name 10 years ago, I’d still be opposed to them. They used to promise to make up losses only if you died while the market was down. But the new ones deliver benefits while you’re still alive. And the protection that they provide against market losses would be very expensive if you tried to buy it in any other way — say, in the options market. So I used to be something of a crusader against variable annuities, but now I fall back on what the economist John Maynard Keynes said when someone challenged him for supposedly flip-flopping. “When the facts change, ” he said, “I change my mind. What do you do, sir?”