In retirement discussions, “portfolio” usually refers to the stocks, annuities*, bonds, and other investments that a saver hopes will help their savings and retirement income to grow. This post will use “portfolio” slightly differently to suggest a broader perspective on retirement and retirement planning. Here, “portfolio” refers to a collection of risks you may encounter in retirement. Your retirement planning should take all these risks into account, including but not only the financial risks, because any of these risks could become a barrier to a successful retirement.
One big risk is that making perfectly rational decisions about retirement, or most anything in the future, is nearly impossible. The reason is “bounded rationality”--that is, limitations on our decision-making abilities. We can’t know everything we need to know, like which risks will be realized and which will not. Our thinking about solving problems is limited. We have too little time, so we can’t gather and process all the information we need or develop all possible solutions. For all these reasons, perfectly rational risk management is beyond our capabilities. The best we can do is to find and implement satisfactory solutions.
The limits on our ability to manage risk explain why some people buy insurance. Insurance protects against a risk without knowing whether and how it will arise and all its consequences. Insurance also can be a substitute for more drastic and costly risk-mitigation measures. For example, there are risks in home ownership that can be partially addressed by homeowner’s insurance, or completely addressed by refusing to buy a house. Insurance might be a satisfactory way to manage some retirement risks, even if it can’t mitigate every risk.
A Portfolio of Retirement Risks
1. The Risk of Outliving Your Retirement Savings: Most of us don’t know how long we will live and how long our retirement will last. As a result, even if we could predict our annual spending in retirement --- an essential component of retirement planning --- we don’t know the number of years for which we should plan. This is longevity risk.
Those with retirement savings encounter financial risks: (a) market risk, the risk that retirement investments will lose value; (b) sequence-of-returns risk, the risk that retirement investments will lose value at the time we plan to retire thereby reducing the value of our retirement income; (c) inflation risk, the risk that inflation will reduce the spending power of our retirement savings; and (d) investor behavior risk, the risk we will make bad decisions about investing our retirement savings, like buying or selling investments at the wrong time.
Careful planning can help mitigate these risks, perhaps with the help of a financial professional. At a minimum, a financial professional should ameliorate investor behavior risk. With or without a financial professional, there are several risk management strategies you could consider with differing costs and benefits. Investing conservatively (e.g., few stocks, lots of government bonds and certificates of deposit) might minimize market, sequence-of-returns, and inflation risks, but the cost likely would be lesser returns on your investments and more inflation risk. Diversifying your investments so only a portion of your savings is exposed to risk might increase your rate of returns, but also your market and sequence-of-returns risks. There are insurance options: annuities with guarantees that protect against market and sequence-of-returns risk, and address longevity risk by providing protected income for the rest of your life. The principal value of the variable annuity will fluctuate based on the performance of the underlying investment options and may lose value.† There is no one correct strategy for every retirement saver, except to consider and plan to manage these financial risks.
2. Other Economic Risks: Before we retire, unforeseen economic events can disrupt both life and a retirement plan: unemployment, a business failure, or the onset of a disability, for example. Whether before or after retirement, family circumstances may change. We may get divorced or suffer the loss of a spouse or partner. An adult child might unexpectedly need financial support. Any of these events can be emotionally disturbing, but also threaten economic stability.
The retirement risk of a personal economic downturn is that we will stop saving, but also we might draw down retirement savings to pay today’s bills. This should always be a last resort. There are costly tax consequences, except in 2020. Also, replacing lost retirement savings is challenging. If we don’t, the result can be significantly reduced retirement income.
There is no perfect safeguard, although advance planning can help. Balancing non-retirement savings with retirement savings can create a financial cushion, if you have the resources. Life insurance can provide a surviving spouse, partner, or other loved one with financial support in the event of an untimely death. Government provides insurance for unemployment and permanent, total disability, and you can buy private insurance for business interruption or loss and disability (some states offer temporary disability insurance). These insurances will help your finances, but usually at a much lower income level. Apart from a pre-nuptial agreement, there is only very limited divorce insurance.1 There’s no divorce from or insurance for our kids’ economic circumstances.
3. Risk of a Too-Short Retirement: The flip side of longevity risk is the fear of dying early in retirement --- for example, at age 70 instead of age 90. The retirement risk is that this fear will keep us from making plans for a long retirement because we fear they could result in a financial loss. For example, annuities provide protected lifetime income. If you fear you won’t live long, you might undervalue annuities’ lifetime stream of income. You might also overinvest in life insurance to protect your loved ones from the financial harm of losing you prematurely. Fear does not produce rational risk management. Unless you know your retirement will be abnormally abbreviated, the better risk management strategy is to plan for a long-lasting retirement.
4. Health Risks: As I said in an earlier post on the Studio, the human body is built to last, but it can’t last forever, at least not so far. So, aging eventually will bring added health risks. In that same post, I offered advice about how you can manage those health risks, including by enrolling in Medicare, investigating long-term care insurance, properly maintaining and caring for your mind and body, and ensuring that you get only the care you want when you can’t communicate your wishes. It’s worth reading again as you prepare a risk management retirement plan.
5. Risk of Loss and Loneliness – According to the University of Michigan’s 2018 National Poll on Healthy Aging, more than one in three adults between the ages of 50 and 80 reported lacking companionship and more than one-quarter felt isolated from others. Women were more likely than men to report feeling a lack of companionship. Perhaps unsurprisingly, living alone also was highly associated with loneliness. In turn, a lack of companionship and social isolation were associated with respondents reporting fair or poor physical and mental health.2
There’s no insurance for loneliness, but there is a solution: plan to retire where and in a way to provide abundant opportunities for engagement with family, friends, and acquaintances. For some, this may mean continuing to work or volunteer so you will have social opportunities and stimulation in a work setting. For others, it may mean living in a community with robust planned activities or connecting with groups and activities where you already live. For still others, it may mean planning to retire to a place near family, friends, and neighbors who will be recreation partners, companions, and emotional support systems.
But it’s not merely where and how you live. The heart of this risk mitigation strategy is people. Your planning should include honest discussions with the people you value in your life about how important their interactions with you will be to your happiness in retirement. I expect they will be enthusiastic about hearing how important they are to you and your future.
6. Unhappiness Risk – Disappointment is the distance between expectations and reality. There is a risk that the reality of your retirement will not be what you expect. In some instances, as in the loss or illness of a spouse, partner, or other family member, the unhappiness may be beyond your control. In others, it can be the product of expectations that are disconnected from the reality of your retirement finances or a failure to address some or all the risks enumerated above.
The latter “unhappiness risk” can be managed with planning and a few calculations. For example, your spending expectations should match the reality of your retirement income. Calculate the retirement income your savings will produce added to your Social Security benefits, annuities payments, and pension benefits. Look at your current spending to predict how much you will spend monthly or annually in retirement. Matching these two numbers will help adjust your expectations. You should also perform the same exercise with the non-monetary aspects of your retirement plans. For example, if you expect to spend time contributing to your grandchildren’s caregiving, make sure your children and their spouses or partners expect the same thing. Again, more planning and risk management will reduce your unhappiness risk.
Living life necessarily involves risk. Retirement is no different in this regard. The advantage of retirement is that you have time to plan how you will manage your full portfolio of risks. You won’t make all the risks disappear, but you can manage them in a way that will prevent them from becoming barriers to a successful, productive, and happy retirement. At its core, that should be the goal of all retirement planning.
1. “What is Divorce Insurance? [Learn How It Works],” Scott Langdon, May, 2020.
2. “Loneliness and Health,” University of Michigan, March 2019.
*What is an annuity?
Annuities are long-term, tax-deferred investments designed for retirement. Variable annuities involve risks and may lose value. Earnings are taxable as ordinary income when distributed and may be subject to a 10% additional tax if withdrawn before age 59½.
Annuities are not for everyone. And, it’s important to remember that these products are meant to be long-term investments designed for retirement, so there are restrictions in place to discourage you from withdrawing all of your money at once or taking withdrawals before age 59½. However, most annuities do allow for exceptions based on specific circumstances such as a terminal illness or other emergencies.
† Optional benefits are available for an extra charge in addition to the ongoing fees and expenses of the variable annuity and may be subject to conditions and limitations. Guarantees are backed by the claims paying ability of the issuing insurance company.
Investing involves risk including possible loss of principal.
The opinions and forecasts expressed are those of the author and individuals quoted and should not be construed as a recommendation or as complete.