There are three risks that are most likely to derail retirement plans. The risks are real and substantial, almost regardless of an individual’s net worth. Fortunately, the potential damage from the risks can be reduced.
Longevity risk is talked about a lot by economists and financial advisors but not by many retirees and pre-retirees. While there are a lot of benefits to living a long time, longevity increases financial risk. You need to pay the living expenses for all those extra years. Also, your annual expenses might increase, because people generally need more medical and long-term care as they age.
Many people underestimate their life expectancy, and that’s why they don’t carefully consider longevity risk. A man who is 65 years old today has a 22-year life expectancy. That means he has a fifty percent probability of living to age 87 or longer, according to the LIMRA Secure Retirement Institute. One in four men age 65 today are expected to live to age 93. Among women aged 65 today, one in four will live to age 96 or longer. Despite a narrowing of the gap in recent years, women still are likely to live several years longer than men in their age group.
Those who are in good health at age 65 need to add additional years to the estimates. The 65-year-olds in good health today are likely on average to live two to four years longer than the entire group. Also, data show that people with more education or higher lifetime incomes or both tend to live longer than the age group average life expectancy. So, if you’re in good health, have a college education (or beyond) and had an above average lifetime income, you should assume you’ll live years longer than your age group average, unless there are health or other reasons to believe you won’t benefit from those advantages.
Married couples need to consider their joint life expectancy when planning, and that can be significantly different than a single life expectancy. There’s a significant probability that at least one spouse will live beyond the average for the age group. In a married couple age 65 today, there’s a 75 percent probability at least one spouse will live to age 88 or longer. Age 93 for at least one spouse is a 50 percent probability for the couple, and there’s a 25 percent probability at least one spouse lives to 98.
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A second risk, which is related to the first, is inflation. Even at the relatively low inflation rates of recent years, the purchasing power of the dollar steadily declines over time. An income that was more than adequate at the start of retirement can be stretched thin after 10 to 15 years of retirement and inadequate when retirement lasts 20 years and longer.
Most retirees face higher inflation rates than the Consumer Price Index (CPI), the widely-quoted measure of inflation. That’s because the expenses that usually increase in price faster than the CPI, such as medical care, take a higher percentage of the average retiree’s regular spending than is accounted for in the CPI.
The price of most goods and services you purchase in retirement will rise over time. Your income needs to increase as well if you want to maintain financial security during retirement.
Investment risk is of course the third risk. Many retirees fund most of their retirement spending through IRAs, 401(k)s, and taxable investment accounts. They rely on income and capital gains earned by their savings to achieve their retirement goals.
Most retirees will be comfortable as long as they earn the historic average long-term returns. But their plans would be upset by a severe bear market in the first years of retirement, something the economists call sequence-of-returns risk. It doesn’t take a bad bear market to derail retirement plans. Many retirees also will have to adjust their plans if the first part of their retirements coincide with an extended period of below-average returns.
One way to reduce these risks is to optimize Social Security retirement benefits. When researching my new book, Where’s My Money: Secrets to Getting the Most out of Your Social Security, I discovered that only about 4% of Americans optimize their Social Security benefits. Most people leave $100,000 or more on the table by claiming their Social Security benefits in ways that reduce their lifetime benefits, according to a study by financial services firm United Income.
Social Security provides income that is both guaranteed for life, no matter how long you live, and is indexed for inflation. For many people, this is their only source of income that has both qualities. Social Security retirement benefits also are paid regardless of what’s happening in the investment markets. So, your Social Security benefits will be paid regardless of how long you live and independent of market returns. They also will increase by the same amount the CPI increases each year. Social Security benefits counter the three greatest risks of retirement: longevity risk, inflation, and market risk.
Social Security seems boring to many people. Instead of focusing on the long term, they claim their benefits almost as soon as the money is available to them. The average retiree is a Social Security millionaire, because that is how much it would cost to buy an annuity with Social Security’s features. But the benefits are even more valuable when you take the time to determine which claiming strategy is likely to generate the highest lifetime benefits for you.
As a general rule, most people should wait to claim their benefits as long as they can, preferably to age 70. In married couples, it’s important for the higher-earning spouse to wait to claim benefits. That’s because after one spouse passes away, one Social Security benefit will end. The surviving spouse has to maintain the household on one benefit instead of the two the couple were receiving. You should want that to be the highest benefit possible. The couple’s lifetime benefits might be maximize if the lower-earning spouse doesn’t wait as long to claim benefits, perhaps claiming them as early as 62.
Social Security benefits are a foundation to retirement income for retirees, even many high-income retirees. For many people, they become more important as retirement goes on, because other income sources are exhausted or lose purchasing power to inflation. You reduce the three greatest risks to retirement and increase your financial security by optimizing your Social Security benefits. In a period of volatile, uncertain investment markets and a weak global economy, guaranteed lifetime income is an important source of security.