At a glance:
Healthcare costs risk
Long-term care risk
Summary of retirement risks
Practical ideas you can start with today
Like all stages of life, retirement carries with it a number of risks that are amplified during this time period.
This is largely the result of the fact that retired folks, by definition, almost always have a decreased and/or fixed income. Other factors of particular concern to the retired community are its increased need for healthcare, as well as a shortened investment time frame, relative to younger groups of people.
Longevity risk is the risk of negative financial consequences as a result of living longer than expected.
Advances in medicine mean that many of us can expect to live — and pay for — 20, 30 or more years beyond the traditional retirement age of 65.
Why it matters
Longevity risk is of particular concern to women. They tend to live a few years longer than men, and the death of a spouse or partner can mean a decrease in income.
As traditional pension plans disappear and more of us become more responsible for funding our own retirement, it will be more important than ever to take longevity risk into account in our retirement planning.
Longevity risks include:
Incurring burdensome medical bills
Losing purchasing power to inflation
Having to fund long-term care
Generally, just having to lower your standard of living to avoid running out of money
Retirement planning, even when done by professionals, often uses one's "life expectancy" when planning for their future. But life expectancy is simply a statistical average. There is a significant chance you will live much longer than average and face one or more longevity risks.
It is therefore essential to recognize how longevity risk may affect you and to have a plan for managing it. Working with a financial planner who also recognizes and shares this concern is a good start.
What can you do?
Here are a few ideas to consider and discuss with your planner:
Convert some of your assets into an annuity from a sound life insurance company to ensure a lifetime income stream, keeping in mind the risks. Learn more about the risks of an annuity.
Before the situation becomes critical, develop a budget by which you will reduce your estimated future expenses without a drastic change in lifestyle
Consider some sort of part-time work during retirement and/or postpone your target retirement date
Convert some or all of the equity in your home into current income through a reverse mortgage, which does not have to be paid back until you no longer live in the house. Make sure you understand the risks of reverse mortgages.
Healthcare costs risk
Healthcare costs risk is the risk that you will face unmanageable out-of-pocket health care costs in retirement. This is undoubtedly among the greatest of many people's fears in retirement planning.
The reality of it
Precisely because folks are now healthier and spend longer in retirement than ever before, this risk has increased greatly in recent decades. The medical advances and new drugs that improve and extend our lives come at a hefty price that now must be paid over a greater expected period of time.
The likelihood of significant out-of-pocket healthcare costs obviously depends on the state of your current and future health, and whether the cost of your care is covered by some form of insurance. It is unrealistic, of course, to count on perfect health for the rest of your life, which means that all but the wealthiest among us need insurance to provide enough coverage to at least reduce out-of-pocket expenses to a manageable level.
However, if you have employer-sponsored healthcare insurance now, keep in mind that your current coverage is not necessarily guaranteed in retirement. Many employers — in both the public and private sector — are scaling back on skyrocketing retiree healthcare benefits. This trend is likely to continue, so that uncovered healthcare costs could increase dramatically in the future.
Most of us plan to rely on Medicare, which is provided to most US citizens at age 65 and covers many healthcare costs. These costs can represent a large portion of your healthcare bill, particularly if you have one or more chronic conditions.
Don't count on Medicare for everything
By no means will Medicare cover all your medical bills, however. For starters, vision, hearing and dental care are not covered. There are significant gaps in coverage, as well as co-pays.
Medicare supplement insurance ("Medigap") is available to help with these costs, but the insurance itself can be expensive. Moreover, given the uncertain economic environment, Medicare may face fundamental changes in the future that would almost surely reduce the scope and amount of coverage.
Managing healthcare costs risk
Healthcare costs can be managed in many different ways, including the obvious — stay healthy by sticking to a sensible lifestyle. Beyond that, you should budget for annual increases in both insurance costs and out of pocket expenses.
A good way to prepare for those expenses is to open a health savings account (HSA). An HSA allows individuals covered only by high-deductible health plans to receive tax-preferred treatment of money saved for medical expenses. These accounts are designed to pay current medical expenses and to build savings to pay for future medical expenses. You can claim a tax deduction for contributions you make, and the income earned on the account is tax-free.
Distributions are federal income tax-free and, in most states, state income tax-free if you pay qualified medical expenses, but are taxable if used for other purposes. The unused balance in your HSA carries over from year to year and can be withdrawn, subject to ordinary tax, without penalty when you turn 65. Keep in mind that you cannot contribute to an HSA when you become entitled to Medicare.
Long-term care risk
Long-term care risk is the risk of losing the ability to live independently, and the associated cost of necessary care. As people grow older, they are more likely to need help performing the basic activities of daily living (basic ADLs), such as:
Transferring (i.e., getting into and out of bed and around the house)
Additionally, there are a number of "instrumental" (ADLs) that, while not necessary for fundamental functioning, are indeed necessary as a practical matter for independent living. These include the ability to:
Take medications as prescribed
Shop for groceries and get around the community for errands or medical appointments
The reason for long-term care risk
Like many retirement-related risks, the need for long-term care is a result of the longer life expectancy we enjoy today. These extra years bring the need for more years of care than were faced by earlier generations of retirees. According to the U.S. Department of Health and Human Services, 70% of people turning 65 years old will need some form of long-term care (LTC) at some point, whether it's round the clock, at home, in a nursing home or just daily visits from a professional or family caregiver.
A shock to the family
To the unprepared, the result can be a strain on the entire family's quality of life and financial stability. This is especially so if LTC is needed for several years, as is common, and if the care is provided by unpaid family members. Keep in mind that government assistance with LTC is only available to the impoverished, through Medicaid.
Moreover, a growing number of elderly, coupled with tight state budgets, means that Medicaid eligibility criteria are likely to become even more stringent in the years ahead. Meanwhile, Medicare — an entitlement for all over 65 — does not cover much in the way of LTC.
The bottom line is that most of us will likely need to pay for LTC, at significant cost. A home health aide, for example, costs about $35,000–$50,000 per year, while a nursing home currently costs upwards of $70,000 per year — far more in some states, like New York and California.
How to manage it
There are really only three ways to manage LTC risk:
Purchase LTC insurance
Pay out of pocket, using a dedicated portion of your retirement savings, or perhaps a reverse mortgage, in which you borrow against the equity in your home
Impoverish yourself to qualify for government assistance
For many of us, LTC insurance is the most practical way to manage LTC risk. It is the only form of insurance that pays for LTC care. It is expensive (several thousand dollars per year), but if you buy at a younger age, the premium will be far lower than if you wait. You will also be less likely to be turned down for coverage.
Inflation is the rise in prices over time, with the result that a dollar will buy fewer and fewer goods and services — your purchasing power decreases. Even low inflation is a "silent thief," and is especially threatening to the security of those who rely on fixed incomes, as many retired folks do.
For example, just 2% inflation — an unrealistically low long-term assumption — means that that something that costs $1.00 today would cost $1.22 in 10 years. Inflation risk is the risk that this process will eventually have a negative impact on your standard of living.
The effects of inflation risk
This impact can take one or more forms. For some, it might simply be that small luxuries can no longer be enjoyed. For others, the loss of purchasing power can mean hard choices regarding the necessities of life, such as food, medical care, gasoline and home heating. Indeed, during difficult times, many find it necessary to move in with family or downsize to a smaller residence.
Dealing with the risk
Retirees might find it necessary to return to the workforce, at least part time. They are particularly vulnerable to inflation risk because retirees tend to rely more on streams of income, such as dividends and interest, that are not adjusted for inflation.
Moreover, since they are older, they can rely less on long-term growth investments that younger people might favor. Finally, the government estimates that inflation in the cost of goods and services purchased by older people tends to be greater than the general, economy-wide rate of inflation.
Sound retirement planning therefore requires that the effect of inflation be taken into account. This might mean you'll need to put more of your nest egg into growth oriented — riskier — investments than you might have initially felt comfortable with, keeping in mind that there is inflation risk in just "playing it safe."
Note that Social Security benefits are subject to annual cost-of-living adjustments. That's helpful, but most people cannot survive on Social Security alone in any event, so this is not a viable solution to inflation risk.
Managing inflation risk
Inflation risk can be managed in several ways, including decreasing living expenses, altering your income streams, or changing your investments. But the sooner inflation risk is taken into account, the more flexibility you will have in preparing for it. For example, you can look into inflation-adjusted annuities. US inflation-adjusted bonds, called "TIPS" (Treasury inflation-protected securities) are another popular option. These products provide monthly income that is adjusted annually for inflation.
What is investment risk?
In broad terms, investment risk is simply the risk that your investments will not perform as well as expected. Digging deeper, we can identify several more specific categories of investment risk. Although experts differ in the way they organize and explain these risks, the important thing is to recognize the basic factors at play, which make good sense when you think about them.
Whether your money is in stocks, bonds, or CDs, you are exposed to investment risk. Investment risk can't be eliminated. But it can be managed — if you take time to make yourself aware of the different forms it can take.
Interest rate risk
With investments such as certificates of deposit (CDs) or US Treasury bonds, there is little risk to the value of your principal investment. Instead, you face interest rate risk: if the rate of inflation outpaces the rate of interest you are earning, you may not accumulate enough over time to keep pace with the increasing cost of living.
With investments that aren't FDIC- or NCUA-insured, such as stocks, bonds, and mutual funds, you face the risk that you might lose money, which can happen if the price falls and you sell for less than you paid to buy. History teaches us that there are several different ways you might lose money on an investment.
Systematic risk is also known as market risk and relates to factors that affect the overall economy and the financial markets. The key feature of systematic risk is that it affects all (or almost all) companies — even investments in financially sound companies are not immune. An unfavorable economic report — at home or abroad — or unexpected bump in unemployment, for example, are among the many factors that can cause the stock market to tumble. Persistent bad economic news or geo-political uncertainty can result in a longer-term downtick in market prices, generally.
The primary means of managing systematic risk is to allocate your investment portfolio among assets that tend to react differently to the same economic factors.
In contrast to systematic risk, nonsystematic risk affects a much smaller number of companies or investments. It is associated with investments in particular products, companies, or industry sectors, because it is based on factors specific to those investments.
Two prime examples of nonsystematic risk are management risk and credit risk:
Management risk, also known as company risk, refers to the risk that bad management decisions, scandals or other missteps will hurt a company's performance and, as a consequence, the value of investments in that company.
Credit risk, also called default risk, is the possibility that a particular bond issuer won't be able to pay interest as scheduled or repay the principal at maturity.
One way to manage nonsystematic risk is to spread your investment eggs among several baskets, diversifying your portfolio holdings within each major asset class — stock, bonds, and cash.
Summary of retirement risks
Life is full of risk from start to finish, but those of us in retirement face particular challenges, primarily based on our decreased earnings, coupled with the uncertainty of how long we will live.
Some of these risks we have examined include longevity risk, healthcare costs risk, long-term care risk, inflation risk, and investment risk. While we cannot avoid these risks, we can prepare for them. And of course, understanding is a prerequisite to preparation.
Practical ideas you can start with today
Evaluate where you stand regarding my exposure to the various retirement risks: longevity risk, healthcare costs risk, long-term care risk, inflation risk, and investment risk.
Find a trusted investment professional to help you manage your risks.
Investigate long-term care insurance from a sound company.
This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.
Read more information and tips in our Retirement planning section