Preparing for retirement has changed a lot in the last few decades. Not only are people living longer because of improved healthcare, but costs have increased dramatically everywhere.
The biggest difference between yesterday’s retirees and today’s retirees is the reduced benefit or pension plan that was replaced by defined contribution plans with 1974’s ERISA (opens in new tab) Formation of the IRA and the Revenue Act 1978 (opens in new tab) Creation of the 401(k). Studies have shown that pensions are and have been rapidly being replaced.
As retirees underestimate their longevity and stock market volatility, the likelihood that they will outlive their savings will continue to decline. Proper adjustments must be made now before irreparable damage occurs.
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Here are the top seven risks retirees should avoid at all costs, along with tips on how to manage them.
1. Longevity risk
Average life expectancy has increased from 68.14 years in 1950 to 76.1 years in 2021. With COVID-19, life expectancy has actually dropped by about 1.2 years, but retirees are living longer. The Society of Actuaries (opens in new tab) estimates that a couple who both live to age 65 has a 50 percent chance that a surviving spouse will live to age 93 (25 percent chance that a surviving spouse will live to age 98).
The greatest threat to retirees is surviving on their savings. While no one knows how long they will live, a 30-year retirement is not uncommon compared to previous generations.
Pro tip: One of the ways to offset longevity risk is to use a three dollar strategy. The purpose is to allocate savings that meet immediate, short-term, and long-term needs. Liquid is all within the next five years; Income is what is needed for 30 years or more; and growth is designed to offset inflation, taxes and future healthcare spending.
In addition, deferring Social Security from full retirement age to age 70 translates into additional pension credits of about 8% per year, meaning a larger benefit later. For example, if you were born in 1954, your full pension would be at age 66. Delaying until age 70 would result in an additional credit of approximately 32% (8% per year for the next four years).
2. Inflation Risk
Inflation is the decrease in purchasing power due to an increase in the price of goods. The average inflation rate since 1914 has been 3.24% and this figure should remain constant, even if the percentages are still relatively high for the next few months. While purchasing power matters in retirement, it can be politicized and exaggerated, especially when supply chain issues and price gouging are present.
Pro tip: Use of Treasury Inflation-Protected Securities (TIPS) (opens in new tab) and Series I bonds (opens in new tab) are an ideal protection against inflation. In 2022, Series I bond interest rates were 9.62%, but they can only be purchased up to $10,000 for each person (up to $20,000 for a pair).
Stay away from speculative or risky investments, including private equity, penny stocks and alternative investments, if they don’t match your risk tolerance.
3. Tax Rate Risk
The Tax Cuts and Employment Act of 2017 (opens in new tab) lowered the top tax rate to 37% from 2018, with most of the laws expiring in 2026, including a lower standard deduction and higher overall tax rates. Whether a retiree is still working or has other forms of taxable income — for example, pension, bank or pension interest, short-term capital gains, ordinary dividends, income from municipal bonds, and withdrawals from pension plans — their Social Security benefits may become taxable.
If the combined income in 2022 is between $25,000 and $34,000 for a single person or between $32,000 and $44,000 for a married couple, up to 50% of their benefits will be included on their tax returns. If the combined income is more than $34,000 for a single person or more than $44,000 for a married couple, up to 85% of their Social Security income is taxed.
That doesn’t even include another tax in retirement — Medicare Part B premiums — which are just $170.10 a month and $578.30 in 2022. For example, for a person with a modified adjusted gross income (MAGI) of $150,000 in 2020, their Medicare Part B premiums in 2022 would be $340.20 per month. Although this amount will adjust in 2023, it depends on what the person’s MAGI was in 2021.
Pro Tip: Converting taxable accounts — such as a traditional IRA or 401(k) — to a Roth in years when income may be lower, and using different tax brackets should keep you in a lower bracket. Nonqualifying annuities (in lieu of CDs and other banking products) offer tax deferral, which can help with both Social Security tax and Medicare Part B premiums.
4. Health care cost risk
In addition to long-term care, healthcare costs including insurance, Medicare Part B premiums, drug costs, co-payments, coinsurance, and deductibles can be costly. loyalty (opens in new tab) It is estimated that the average retired couple aged 65 will need to save about $315,000 (after tax) in 2022 to cover their retirement expenses. If taxable accounts are used, this amount may be higher when potentially paid taxes are taken into account.
Unless the American healthcare system changes, costs are inevitable, so it’s ideal to be prepared. Retirement spending might be lower for some than others, but sentiment is that it will most likely increase overall.
Pro Tip: Using a Health Savings Account (HSA) provides tax-deductible contributions that grow tax-deferred, and withdrawals may be tax-free if used for health care expenses. In 2022, the maximum contribution limits are $3,650 for an individual and $7,300 for a family. If you are over 55, there is an additional catch-up contribution of $1,000. In addition, qualified HSA financing sales (opens in new tab) allows for a one-time “trustee-to-trustee” transfer of up to an annual contribution (whether individual or family) from IRA or Roth IRA.
5. Risk of long-term care costs
The costs of long-term care are by far the most devastating to a retiree’s savings and investment portfolio. With the cost of home health care, assisted living, and skilled nursing increasing at an average rate of 1.71% to 3.64% or more per year, what they cost today could easily double or triple if you need care.
According to a Genworth 2021 Cost of Care Survey (opens in new tab), nursing home care averaged $61,776, assisted living averaged $54,000, and a semi-private nursing home room averaged $127,538 per person in 2021. By 2051, home nursing care should be about $149,947, assisted living about $131,072, and a semi-private nursing home room about $230,347.
Pro Tip: Long-term care insurance has been the solution recommended by insurance agents and financial advisors for years. The problem is that unguaranteed premiums allow for other types of “hybrid” policies — for example, life insurance and annuities — with long-term care insurance as a viable alternative. Keep in mind that there are different types of policies, so explore how each works.
6. Lifetime income risk
Up until the 1980s, retirement plans made up a significant portion of a retiree’s income. According to the Bureau of Labor Statistics (opens in new tab), this figure has fallen significantly to below 20% for workers in the private sector. The Pension Law Center (opens in new tab) states that only 31% of older Americans have a pension.
Pensions used to be the mainstay of the “three-legged chair,” which also consisted of Social Security and savings, a concept presented at a 1949 Social Security Forum. But today’s retirees often have to figure out for themselves how to meet the most important aspect of creating a guaranteed income stream that they won’t outlive.
Pro Tip: For many retirees, not having a guaranteed income is a major financial problem. Immediate annuities and indexed annuities with income tabs focus on the payout phase of retirement. Using the same investments during the accumulation phase and not reallocating them properly reduces the probability of success that these assets will not last a lifetime.
The SECURE Act of 2019 (opens in new tab) allows employer plans including 401(k)s and government plans such as 403(b)s to access lifetime income options without having to transfer them to an IRA.
7. Stock Market Risk
As retirees age, their tolerance for market risk should decrease. Yield implication risk is the risk of prematurely achieving lower or negative returns when withdrawing money in retirement, which can significantly reduce the overall life of these assets.
Old-fashioned rules like the 4% withdrawal rule have been used by retirees since the idea was first published in the Journal of Financial Planning in 1994. It states that a safe withdrawal consisting of 60% stocks and 40% bonds is the ideal way not to run out of money. However, due to low interest rates, this rule has been questioned as data suggests it should be lowered from 4% to around 2.95% to 3.3%.
There’s also another old rule about proper portfolio balancing by age known as the 120’s rule (formerly known as the 100’s rule). It suggests subtracting your age from 120 to get the correct percentage of stocks and bonds in your portfolio. For example, if you’re 55 years old, subtracting 55 from 120 means you should invest 65% in stocks and 35% in bonds. The problem with this solution is usually the timing and intervention of human nature.
Pro Tip: Don’t use outdated rules to dictate your optimal exposure to the stock market. Reassess your risk tolerance and focus on saving instead of chasing higher investment returns.
This article was written by and represents our contributing consultant, not the Kiplinger editorial board. You can check advisor records with the SEC (opens in new tab) or with FINRA (opens in new tab).