Are you worried about outliving your retirement savings? Or a long costly stay in a long-term-care facility? Or concerned that steep inflation is eroding your nest egg? Retirees fear all of these things and more. But these risks aren’t the only dangers that loom over retirement savings. Some lesser-known risks can be tremendously problematic as well.
Bottom Line Personal asked wealth manager Lane Martinsen to discuss the retirement-planning risks that receive too little attention until it’s too late…
Sequence risk. Every retirement saver understands that the stock market has its ups and downs, but most reassure themselves that stocks reliably deliver strong returns over extended periods. But: The retirement plans of even long-term savers can be devastated if the market hits a rough stretch just as their retirement begins and they start living off their savings. Example: Two investors each retire with $1 million in their brokerage accounts and withdraw $50,000 the first year and every subsequent year with a 2% annual increase to keep pace with inflation. Each enjoys a 6% annual average gain—most years their portfolios gain value, but both retirees experience a two-year stretch where their portfolio values fall by 15%. The only difference: The first endures this 15% decline during the first two years…while the second is hit by it during years 10 and 11. Result: The first retiree’s account runs out of money in year 18, while the second still has around $400,000 in his. (This example does not take into account taxes or fees or RMDs.) Each investor did exactly the same thing and enjoyed exactly the same average annual returns. The difference was when their losses occurred.
What to do: Somewhat insulate your retirement savings against “sequence risk” by including investments in your portfolio that provide principal protection as well as growth. These might include…
Single-premium immediate annuity. This is a straightforward annuity where the investor makes one large payment, then immediately starts receiving regular payments over a set period or for life.
Fixed index annuity—a type of annuity that is tied to a specific market index but that still provides principal protection during down markets.
Another option: Postpone retirement or return to the workforce if the market experiences a setback just as you intend to retire. You don’t have to go back full-time to avert sequence risk danger—just earn enough to pay your bills so you don’t have to pull much money out of your savings until the market rebounds.
Tax risk. Retirees look at the money they’ve saved in their 401(k)s and IRAs and think, That’s my nest egg. But that’s not entirely accurate—while much of the money in traditional 401(k)s and IRAs belongs to the account holder, a significant slice of it eventually will be claimed by the government. Unlike Roths, which build up tax-free income, these accounts are tax-deferred and the money will be taxed at the retiree’s ordinary income tax rate when it is withdrawn. Those rates might be higher than many retirees expect for two reasons…
A retiree’s taxable income tends not to decline as sharply as he expects in retirement, so his tax bracket often remains relatively high.
There’s a good chance Washington will raise tax rates in the years ahead. Today’s tax rates are historically low and already are slated to increase starting in 2026 if no action is taken by the government…and Washington has amassed unprecedented debt and continues to spend.
What’s more: Retirees face a pair of tax challenges that younger taxpayers do not—the tax brackets for Social Security benefits are not indexed to keep pace with inflation. That means an ever-increasing share of retirees must pay income taxes on up to 85% of their benefits…and Medicare recipients with significant income must pay surcharges that can dramatically inflate their Medicare premiums, effectively a hidden additional income tax on retirees.
What to do: Consider converting money held in traditional IRAs and 401(k)s to Roth IRAs. You will have to pay income taxes on this money in the year of the conversion, but that could cost less than paying the likely steeper tax rates of the future. While high earners might not be eligible for Roth “contributions,” Roth “conversions” are available to everyone. There is no early distribution penalty on the converted dollars, but there is a five-year clock before which earnings on the converted dollars become tax-free. Taxes and penalties might apply if the gains are withdrawn less than five years after the conversion.
Other strategies that could reduce retirees’ future income tax bills: Purchasing cash-value life insurance…and/or taking out a home-equity conversion mortgage—that’s the most common type of reverse mortgage. Reverse mortgages have a terrible reputation, but the laws have changed, and these days, they truly can, in some cases, be useful financial products capable of generating money that isn’t considered taxable income.
Withdrawal risk. In the 1990s, a paper published in Journal of Financial Planning by William Bengen concluded that 4% was a safe annual withdrawal rate for most retirees. Example: A retiree who had $1 million divided evenly between stocks and bonds could withdraw up to 4% of that savings—$40,000—in year one of his retirement, then remove that same amount adjusted for inflation in each ensuing year with minimal risk of outliving his/her money. This “4% rule” became a tenet of retirement planning…and Bengen’s conclusion was correct—based on the data available at the time.
But: Bond yields fell dramatically in the quarter century that followed, undermining the returns of the fixed-income segment of the traditional 50-50 stock-bond retirement portfolio. Retirees who had been led to believe that withdrawing 4% per year was 100% safe actually were at risk of outliving their savings. Bond yields have rebounded somewhat recently, but the point of the 4% rule wasn’t that it made sense based on the way things happened to be at the moment—it was that it could be counted on to hold up in any environment, something we now know to be untrue.
What to do: If your priority is minimizing the odds that you will outlive your retirement savings and you have a traditional retirement portfolio that’s divided roughly evenly between stocks and bonds, set your annual withdrawal rate at 3%, not 4%. A different safe withdrawal rate might apply if your portfolio is significantly different from that 50-50 stock-bond mix, in terms of weight or in terms of the types of assets/securities.
Early-stage cognitive decline risk. Cognitive decline can lead to extended stays in assisted-living facilities. But it also can put retirees’ finances at serious risk long before they require that level of care—potentially even before they realize they’re experiencing cognitive decline. A study by researchers at University of Alabama School of Medicine found that financial capacity and judgment are significantly impaired in people suffering from mild early-stage Alzheimer’s disease—even though these people are not yet greatly diminished and still perfectly capable of taking care of themselves in most ways. That fading judgment might lead to mis-investing or misspending retirement savings or falling victim to financial fraud.
What to do: Have a durable financial power of attorney drawn up before you need it. This estate-planning document lets you appoint someone to manage your finances on your behalf if you become unable to do so yourself. If you’re married, both spouses should be involved in financial decision making so that they can keep an eye on each other’s money. Be honest about your declining financial ability should it occur, and open to concerns along these lines from your loved ones.
Divorce risk. The divorce rate among Americans age 65 and older has more than tripled in the past 30 years, from 1.79 per 1,000 married people each year in 1990 to 5.6 in 2019. The damage done by retirement-age divorce is daunting because it’s too late to make up lost financial ground by increasing savings.
What to do: Consider marriage counseling.