YOUR MONEY: Strapping in for a bumpy retirement rideAs equations go, it's a simple one: There's risk and there's return. Unfortunately, human nature being what it is, people tend to focus on one side of the equation to the exclusion of the other. Prior to October, many retirees and would-be retirees - despite warnings from countless pundits, academicians and the like - focused mostly, if not solely, on return. Now, however, the pendulum has swung in the complete and opposite direction and everyone is talking about the risks associated with retirement.
By: Robert Powell, MarketWatch
BOSTON - As equations go, it's a simple one: There's risk and there's return.
Unfortunately, human nature being what it is, people tend to focus on one side of the equation to the exclusion of the other. Prior to October, many retirees and would-be retirees - despite warnings from countless pundits, academicians and the like - focused mostly, if not solely, on return. Now, however, the pendulum has swung in the complete and opposite direction and everyone is talking about the risks associated with retirement.
At this point, everyone is all too familiar with stock market risk. But what are the other risks? What's the likelihood of encountering them? And what can be done to manage those risks? Thankfully, the number crunchers at the Society of Actuaries have spent a few years, and then some, developing a list of the 15 risks one might face in retirement.
Here's a look at five of those risks and, more important, the ways to manage them. The trick, of course, is trying to figure the right balance of solutions given all the risks you might face. For some, it might mean more stocks and fewer safe or guaranteed products. For others, it might mean more safe or guaranteed products and fewer stocks.
1. LONGEVITY RISK
This is, in many ways, the biggest risk and the most difficult to figure out. We know that life expectancy in the United States is now 78 years and that on average women outlive men. But that doesn't tell us a thing about how long you might live. It just means that half the population will live beyond 78 and the other half will die before age 78, and, more likely than not, many of those living beyond age 78 will be women.
"Long lifetimes are difficult to predict for individuals," according to the SOA's report, "Managing Post-Retirement Risks: A Guide to Retirement Planning."
"It's easier to predict the percentage of a population with a long life than to predict this for an individual," the report said.
Given that, what's the best way to manage that risk? Social Security, traditional pensions and payout annuities all promise to pay an individual a specified amount of income for life, according to the SOA. But some newer products can help protect retirees against outliving their assets as well. Those include a reverse mortgage; "longevity insurance," which is an annuity that does not start paying benefits until an advanced age such as 85; and perhaps "managed payout" plans.
2. INFLATION RISK
For anyone planning for or already living in retirement, inflation is an ongoing and constant concern. But even though we know that inflation has averaged 3 percent since 1913, it's also true that it's gone up nearly 9 percent in some decades and it's fallen nearly 2 percent in another decade. What's more, we know that the cost of living for retirees is very different than it is for workers. In short, there are no guarantees when it comes to predicting the cost of living in the future. So what can be done to manage that risk?
"Many investors try to own some assets whose value may grow in times of inflation," the SOA said.
"However, this sometimes will trade inflation risk for investment risk." Those risk management tools include: common stocks, inflation-indexed Treasury bonds or TIPS, inflation-indexed annuities, and commodities and natural resources.
3. INTEREST RATE RISK
Retirees and would-be retirees hate times like these, when interest rates on both short and long-term instruments are low. Retirees tend to have less income they can spend, and they may be forced to re-invest their money at lower rates. And pre-retirees who might be investing in fixed income have to save more to build larger nest eggs. When it comes to predicting interest rates, the SOA said government spending, inflation and business conditions tend to be the drivers.
But as with many of the risks associated with retirement, it's difficult to predict the future direction of interest rates. So what can be done to manage this risk? The SOA recommends immediate annuities, long-term bonds, mortgages or dividend-paying stocks.
4. STOCK MARKET RISK
It might be an understatement, but the SOA notes that "stock market losses can seriously reduce one's retirement savings." That, and then some. Suffice to say, as with the other risks, it's impossible to predict what will happen to stocks.
But it is possible to manage this risk, the SOA says, by diversifying widely among investment classes and individual securities, and being prepared to absorb possible losses. "Because such losses may take many years to recover, older employees and retirees should be especially careful to limit their stock market exposure," the SOA says.
In addition, the SOA says hedge funds may offer some protection, but they can be complex and have high expense charges. Another tool of choice: Financial products that invest in stocks, but guarantee against the loss of principal.
5. BUSINESS RISK
Lots of bad stuff can happen to retirement funds. Employers who offer defined-benefit plans can declare bankruptcy. Insurers who sell annuities can become insolvent. The list goes on. You can gauge whether your employer is safe by its credit rating or whether your insurance is safe by it claims-paying ability rating. But you still need to manage this risk. The Pension Benefit Guaranty Corp. insures - up to certain limits - defined-benefit pension plans of employers that go belly up. And owners of annuities are covered by state insurance company guaranty funds up to specified limits should the insurer become insolvent.
PLUS 10 MORE RISKS
The other 10 risks associated with retirement are: business risk; public policy risks; unexpected health-care needs and costs; lack of available facilities or caregivers; loss of ability to live independently; change in housing needs; death of a spouse; other change in marital status (read: divorce); unforeseen needs of family members; and bad advice, fraud or theft.
What are the ways to manage these risks? Consider the following: Phased retirement, bridge jobs, and postponing retirement can mitigate employment risk. Owning municipal bonds, Roth IRAs and Roth 401(k)s can mitigate public policy risks. Owning Medigap insurance or working for an employer that provides health insurance can reduce the risk of having unexpected health-care needs.
Relocating to an area that has plenty of health-care workers can help one deal with the lack of available facilities or caregivers. Consider buying long-term care insurance to deal with the loss of one's ability to live independently.