(BPT) - Thirty years ago, most Americans could safely rely on Social Security and a pension to provide the income they needed in retirement. That’s no longer the case. Today, you carry much of the responsibility for creating your own retirement income plan.
As Americans live longer, active lives, retirement is increasingly no longer an end stage but instead a transition point. That presents a problem, as it creates greater risk of outliving your retirement savings. An income mindset and a comprehensive retirement income strategy are essential to overcome this risk and live your ideal retirement lifestyle.
Whether plotting your own course or working with a qualified financial professional, you’ll need to develop a retirement income strategy that ensures your retirement portfolio lasts your lifetime and manages these seven key risks to retirement income:
1. Market Volatility
Market trends are one of the most important factors in ensuring assets last throughout retirement — perhaps second only to your withdrawal rate from retirement savings. You’ve likely spent decades saving for retirement, but once you stop contributing and start withdrawing, your nest egg becomes more susceptible to market risks. Chances are most retirees will have to live through at least one bear market. In fact, the average retiree will likely face three to five such bear markets in retirement. The average bear market lasts 14 months with an average loss of 33 percent. Assuming no withdrawals are taken from their retirement savings, on average, it will take an investor 25 months to recoup those losses. If you are retired and taking withdrawals from your retirement accounts, however, it could take you longer to recoup those losses — or those losses could become permanent.
2. Sequence of Returns
During the accumulation phase of retirement planning, the sequence of returns doesn’t much matter — it’s the average rate of return that is important. When withdrawing during retirement, however, the sequence of returns matters greatly. Beginning your retirement in a time of positive market performance increases the chances that retirement savings will last a lifetime. However, negative market returns in the early years of retirement will likely require you to liquidate more investments to provide the income you need — raising the likelihood of depleting retirement savings sooner. In the latter case, holding off on liquidating assets, if possible, can help extend your retirement resources.
3. Interest Rates
While interest rates have gradually risen over the past 12 months, they remain low enough to create additional pressure for the average retiree to generate the income they need to live comfortably in retirement. In the past, many could rely on an interest rate of 5 percent or more on investments in secure assets like U.S. Treasury notes. In today’s lower interest rate environment, however, retirees might need to withdraw more from their retirement savings to make up the shortfall caused by low interest rates or look to invest more aggressively in search of greater yields.
Inflation risk is purchasing power risk — that is, the chance that investment income today will not be worth as much in the future. Inflation is typically measured by the Consumer Price Index (CPI) produced by the United States Department of Labor (DOL). Since 1983, the CPI has increased annually by 2.6 percent. For retirees, however, the DOL has another consumer price index, the CPI-E, which has increased by 2.8 percent on average each year since 1983. Why the difference? Rising healthcare costs, which run 70 percent higher for the elderly, have driven increased demand on retirees’ income and are most damaging in later years of retirement.
5. Withdrawal Rate
You’ll need to be mindful of how much you withdraw from your accounts each year, seeking a safe and sustainable withdrawal rate that runs little probability of depleting retirement savings over your lifetime. The right withdrawal rate is dependent on several factors including age, length of retirement, asset allocation, market conditions and interest rates. A 4 percent withdrawal rate was long viewed as safe and sustainable. In light of people living longer in retirement and a prolonged low interest rate environment, new research suggests a sustainable rate may be closer to 3 to 3.5 percent for most retirees.
6. Investor Behavior
Investor behavior has a profound impact on portfolio performance. Investors are often influenced by their emotions — from excitement and euphoria to fear or panic — which can disrupt a long-term investment strategy. We have an aversion to loss that can affect our willingness to stay in the market. Investors will often get in and out of the market at the wrong time — investing when stock prices are up and pulling out when they fall. Case in point, according to DALBAR, over the past 10 years, the S&P 500 gained an average of 8.5 percent while the average equity mutual fund investor earned only 4.9 percent. To benefit from any potential long-term market appreciation, you should consider remaining invested through difficult times.
Longevity risk is the risk that you will outlive your money. When creating a strategy for transitioning savings to retirement income, the issue of longevity must be addressed. A 65-year-old married couple has nearly a 50 percent chance that one member will live to age 94 and a 25 percent chance to age 98. Of course, the challenge is how to generate income that will last 30 years or more.
Creating income security and ensuring a successful and happy retirement is no easy task. But there are plenty of resources available to help, from financial professionals who can help you develop your unique income strategy to checklist resources like those available from the Alliance for Lifetime Income.
You’ve been saving and preparing for retirement, perhaps for your entire working life. As you begin to transition into the longest vacation of your life, you should make sure that your retirement income plan is structured to withstand these seven common risks.