As the largest segment of the population prepares for and enters retirement, there has been an increased emphasis on researching and analyzing the unique risks retirees face.
When we separate from service we transition from wealth accumulation to wealth distribution. Dr. Pfau, one of the industry’s leading researchers states, “traditional wealth management approaches do not sufficiently address a retiree’s needs”. Retirees face additional risks and as such there is a dramatic difference in the decision making of someone who is saving for the distant future and someone who is relying on their nest egg today.
So in this article we will explore the 7 biggest risks a Federal retiree faces, often for the first time, upon entering into retirement. The goal here is to emphasize that retirement is a different animal with its own unique risks which, in turn, have their own unique solutions to learn about and potentially incorporate.
1. Sequence of Returns Risk
Sequence of Returns Risk is first introduced when you begin distributions from your retirement nest egg. It refers to the order of the returns you experience after starting to draw down an account. In retirement, our bi-weekly paycheck is gone, so we rely on distributions from our nest egg to supplement our income and maintain our lifestyle – but we need those regular distributions regardless of what the market is currently doing.
So if we take our normal withdrawal during a down market, that same dollar amount actually represents a larger percentage of your retirement nest egg, which leaves less principal in the account to rebound with the market and compound over time.
This is a complex concept, so let me oversimplify it in a quick example. Lets say you have $100 dollars in your nest egg and in the next two years the market will go +50% and -50%. If you are not withdrawing from the account, it doesn’t matter if it goes up first or down first because you still end up with $75.
$100 + 50% = $150. $150 – 50% = $75
$100 – 50% = $50. $50 + 50% = $75
But what if you needed to take $20 out at the end of each year to support your retirement lifestyle? Before distributions, the sequence of the returns you experienced wouldn’t have mattered, but when we start spending the account down its a different story…
$100 + 50% = $150 – $20 = $130. $130 – 50% = $65 – $20 = $45
$100 – 50% = $50 – $20 = $30. $30 + 50% = $45 – $20 = $25
The average returns are exactly the same (0%) in both sequences but the net result is VERY different because of the effect that the order of the returns has once we have begun distributions.
We cannot control what the market is going to do upon our retirement, we can only control our exposure to it, so for those with heavy market exposure that experience a negative sequence of returns early in retirement, there is a much higher likelihood of running out of money during their lifetime.
2. Inflation Risk
Inflation means that the cost of goods increases over time. Inflation has an erosive effect on the spending power of your nest egg. If you have $100 and it earns 2% in a year where inflation grows 3%, even though your account grew to $102 it has less purchasing power than it did the year before with only $100! The same concept holds true for the COLA’s on your pension and Social Security benefits.
Inflation, compounded over 20+ years of retirement, can easily force you to spend twice as much money to maintain the same standard of living in your later years. It is a daunting task to try and squeeze twice as much apple juice out of the same number of apples but it is much worse for those in the private sector without COLA adjusted pensions that they cannot outlive.
3. Interest Rate Risk
This goes hand in hand with inflation, because when interest rates are as suppressed as they are today it means that many low risk investments lose ground to inflation each year – causing us to spend down the principal faster.
Additionally, as we enter a rising interest rate environment it poses a distinct risk to bond holdings. When interest rates increase, a bond’s sale value generally decreases because newer bonds would be issued reflecting the higher interest rates. Learn more here.
Interest rate risk generally hits those on a fixed income the hardest because it is tough to lower your market exposure, while still outpacing inflation, when the G Fund is only averaging 1.96% return over the last 5 years (and may continue to be suppressed further).
4. Public Policy Risk
This is the terminology used to describe the risk that Uncle Sam might change the rules of the game, perhaps by:
- increasing tax rates (income, FICA, etc)
- decreasing Social Security, Medicare, or Medicaid benefits
- changing IRA, 401K, or Roth IRA contribution limits or RMD rules
- decreasing retiree benefit calculations
- further suppressing the G Fund returns
- subsidizing less of a federal retirees FEHB
The biggest of these risks is generally thought to be a tax increase. We are nearly $20,000,000,000,000 (that’s 20 trillion buckaroos for the kids keeping score at home) in debt and severely underfunded in both Social Security and Medicare with the largest segment of the population just starting to qualify for those benefits… so protecting your nest egg from increased income tax rates may be a prudent discussion to have with your accountant or advisor.
5. Unexpected Healthcare Costs
We often think of protecting our nest egg from market losses, but let me ask you, if 20% of your money disappears overnight does it matter if it was due to market loss, a medical emergency, or a nasty bingo addiction? NO! The impact on the sustainability of your retirement lifestyle is the same regardless!
The average cost of newly approved cancer treatments run $10,000 – $30,000… PER MONTH! A hemorrhagic stroke can cost $19,500 before rehabilitation even begins. These numbers don’t reflect the additional costs associated with recovery such as lost wages for you and/or a spouse, travel expenses to receive quality care, or the long term effect of routinely paying for additional prescriptions or treatments.
In addition to having an emergency reserve fund, we protect against these risks with insurances. Thankfully Uncle Sam subsidizes 72% of your FEHB, but remember comprehensive health coverage still has a number of gaps. Some may look to fill them by purchasing additional insurances with a single specific use, such as cancer insurance or disability insurance. These single focus approaches can work great IF you qualify to receive their benefit, but would a cancer policy help if you were hit by a bus? Nope, not at all. So you can see why many folks not named Mrs. Cleo (the fortune teller) prefer a strategy that emphasizes flexibility, allowing one policy to protect you from many different risks while affordably complimenting your FEHB.
6. Loss of Independence
There is also the risk of losing our independence, which comes with the additional expenses associated with assisted living or nursing homes. A private room nursing home in Charlotte, NC currently averages $7,543 per month!
There are many approaches to LTC planning, from the traditional LTC insurance to Hybrid Life Insurances policies with LTC riders to Life Insurance policies with the more flexible Chronic Illness Riders to Asset-Based LTC strategies. Each has pros and cons. But regardless of which approach you explore, keep in mind that eventually every one of us will see our independence diminished to some degree, so it is critical to discuss a plan to age gracefully.
If your crystal ball worked perfectly, you would only buy one type of insurance!
If insurance was free, you would carry every type of insurance ever created!
But since neither of those are true, the flexible approach of Living Benefit Life Insurance, with its ability to accelerate payments of the Death Benefit during the insured’s lifetime, is one of the most cost-effective ways to squeeze holistic protection into your monthly budget.
7. Longevity Risk
Longevity Risk comes last because the risk of living longer than your planned to is not just a risk… its a risk multiplier! All of the risks already discussed continue to increase the longer we live!
Inflation and interest rate risk may not dramatically impact someone with an abbreviated 10 year retirement but it will absolutely have a major impact when compounded over the course of a 40 year retirement! We become more likely to face added healthcare expenses or those expenses associated with the loss of independence the longer that we live as well. Thus it is critical to establish a sustainable budget that you continue to adapt and update throughout your retirement.
As a Federal Employee, you already have a major leg up on most of the private sector and, with proper planning, the risks we’ve discussed can largely be nullified, but to do it right takes an open mind and a determined effort to educate and empower oneself.
As you can now see, there is much more to creating a Holistic Retirement Plan than just making sure you have enough money to pay each month’s bills. A good Federally Focused Retirement Planner should help educate you on these risks and continually assist you in balancing your asset allocation, FERS/CSRS benefits, and insurances to provide the proper blend of growth and protection for you, your family, and your nest egg.