Tue, 18 Nov 2014
Morningstar's Christine Benz offers solutions for facing a bear market early in retirement, outliving your money, falling behind inflation, and managing high health-care expenses.
Note: This video is part of Morningstar's November 2014 Risk Management Week special report.
Jason Stipp: I'm Jason Stipp for Morningstar. Although some risks are common to all investors, such as the risk of overpaying for an asset, other risks are specific to age bands. Here to talk about four key risks facing retirees is Morningstar's Christine Benz, our director of personal finance.
Christine, thanks for joining me.
Christine Benz: Jason, it's great to be here.
Stipp: We've often talked about how things get a little more complicated when you get into retirement, and that includes the array of risks that need to be on your radar. You brought four key risks today. The first one is something called sequencing risk. What is that?
Benz: Basically, that's the risk that you'll encounter a really lousy market at the outset of your retirement. The reason that this is so problematic is that if your overall investment funds are shrunken, that means that if you're taking withdrawals you're taking them from a shrinking pool. And that leaves less in place to rebound when the market actually recovers. So, this is a big problem. This is something that financial-planning expert Michael Kitces has really been delving into, trying to help retirees figure out how they can help mitigate that bad sequencing risk.
Stipp: So, obviously, we have no control over what the market does or when it does it. So, how can you mitigate that risk?
Benz: I think one of the key things that you can do is to make sure that your retirement portfolio is appropriately asset-allocated. So, you have enough in the safe stuff to draw upon if equities start out on a bad note as you embark upon retirement. So, this is one reason I've been working so much on this bucket idea. That's one of the key ideas there, that if you're holding enough in cash and in, say, short- and intermediate-term bonds, that will be able to tide you through several years' worth of a lousy equity market. It gives you a cushion. You don't want to hold too much in very safe securities because there's obviously an opportunity cost. But you at least want to make sure that if at the front end of your retirement you encounter that lousy market that you have that cushion built in that you can draw upon.
Stipp: Another way to mitigate that risk is if a down market does happen during your retirement years, take a good hard look at your spending patterns.
Benz: Right. This has been another area that academic researchers have been delving into in the realm of retirement planning: withdrawal rates, what they should look like, how they might fluctuate over the years. And I think it is emerging as a best practice that retirees, if they possibly can, be flexible about their withdrawal rates. That will greatly improve their portfolio sustainability. And one of the key things to do, if you do encounter one of these bad markets, is to reign in your spending a little bit.
At a minimum, you should forgo taking an inflation adjustment in your paycheck during the year in which the market is down. T. Rowe Price had some great research that pointed to the value of doing just that--so not even necessarily cutting the dollar amount that you're pulling from your portfolio but just not taking that inflation adjustment. That can add at least a little bit to the portfolio's sustainability level. So, there are some things you can do around the margins.
Stipp: The second key risk, Christine, is a curious one. It's longevity risk. We'd like to all think that we will have a nice long period of retirement. But there are also some risks to living very long into retirement as well.
Benz: Absolutely. In a lot of ways, longevity--even though it's such a good thing in so many ways--is really at odds with a portfolio's sustainability. So, the longer you live, the more you have to make sure that you're putting up a good defense against that longer time horizon.
Stipp: So, some of the ways you can do that include, first of all, deciding when you're going to take Social Security?
Benz: That's right. I think you want to take stock of all of your lifetime guaranteed income sources, and Social Security would be the starting point for most people. If you can delay the Social Security start date even just a couple of years past your full retirement age, you can pick up a significant increase in your benefit--and, again, that's a lifetime benefit. So, if you are able to delay, you will reap the benefits over however many years you live thereafter.
Stipp: And for folks who think they may have a long retirement, they might want to consider annuitizing part of their portfolio?
Benz: That's right. Here, again, the idea is to maximize those guaranteed lifetime income sources. Longevity insurance has cropped up as the most direct hedge against longevity. The key idea is that you buy this policy at a date like 65, and then it starts paying out to you at a later date--maybe 80 or 85, something like that--and then will provide you, again, that income for the rest of your life.
Stipp: And if you're one of the lucky ones that has a pension, you may have the choice of a lump sum or an annuity. I'm imagining if you think you'll have a long, long retirement, you may want to pick the annuity.
Benz: Absolutely. That is typically the choice when someone is deciding to spend from a pension. And if you are someone who has reason to believe that you have longevity on your side, the annuity will generally be the better option.
Stipp: When it comes to your investment portfolios, those who think that longevity is on their side might want to take a close look at their withdrawal rates.
Benz: Absolutely. A lot of the research that's been done about withdrawal rates in retirement centers around, say, a 25- or 30-year time horizon. If you are someone who retired very young or maybe retired at a traditional age but think you'll live to be a very old age, you want to make sure that you are thinking about that long time horizon and, to me, that calls for having perhaps a more modest withdrawal rate than that 4% rule of thumb. It might call for having, say, a 3% withdrawal rate instead.
Stipp: And a very long time horizon in retirement may also affect how you allocate your investment assets.
Benz: Absolutely. If you have money that you expect to tap, say, after year 10 of retirement, to me that money should be parked in stocks, which have much greater long-term growth potential than cash and bonds. Historically, when we look at market data going back many, many years, what we see is that over 95% of 10-year rolling periods equities actually have a positive return. So, in sort of an upside-down way, that's the safest asset class to be in if you have a very long time horizon. There's a very good chance that you'll end up with a positive return over that holding period.
Stipp: That leads into our third big risk that retirees need to manage, and that's inflation risk. How important is this for retirees?
Benz: It's absolutely crucial. And one of the key reasons is that that portion of your income that you're drawing from your portfolio is not inherently inflation-protected. Your pension payments might be, you Social Security benefit is. But that part that you're taking out of your portfolio is not going to necessarily preserve your purchasing power unless you add additional insulation to do so.
Stipp: So, some of the ways you could mitigate that could just be asset allocation--again, maybe looking to more stocks.
Benz: Absolutely. So, as I said, stocks are the asset class that will give you the best shot at out-earning inflation. Also, to the extent that you have bonds in your portfolio, I think you want to remember that inflation is one of the natural enemies of bonds--at least nominal bond types--because you're getting a fixed payout from those bonds and, as the years go by and as inflation increases (as it inevitably will), that means that the purchasing power of that income stream is going to go down, down, down. So, you do need to make sure that if you have bonds in your portfolio, you're thinking about layering on some explicit inflation protection in the form of Treasury Inflation-Protected Securities or perhaps I-bonds.
Stipp: And if you have other types of income streams--say, insurance, longevity insurance protection--you may also want to make sure that some degree of inflation protection there is baked in.
Benz: Certainly, that's the case. So, if you are able to partake of some sort of inflation rider, I think that's generally a good idea. Long-term care insurance, for example, you'll pay more to have that inflation protection embedded in your policy, but it's generally a good idea. Historically, those rates of inflation in terms of long-term care have risen higher than the general inflation rate. So, oftentimes, it can make sense to make sure that you lock in that inflation protection.
Stipp: And again, when you're thinking about inflation protection, delaying Social Security can pay off as well in this case.
Benz: It can because the idea is that if your baseline benefit is higher than it otherwise would be, that means that the inflation protection, the inflation adjustments you get with Social Security each year will be magnified. So, that's another thing to do when you're thinking about inflation-protecting your whole income stream.
Stipp: The last key risk that should on retirees' radars is related to health care: your own health care but also health-care expenses.
Benz: That's right. So, for many retirees, if they have Medicare and they also have purchased a supplemental policy, their medical expenses will be covered fairly reasonably--also if they have Medicare Part D covering their prescription-drug benefits. But I think the real wild card for anyone embarking upon retirement is long-term care costs, which are not covered by any of the above. So, you need to make sure that you're thinking about [whether you are either going to] insure against these costs, which can be catastrophically high, or [if you are] going to try to self-fund them, in which case it makes a lot of sense to make sure that you're setting aside a separate pool of money that you're not considering when you're thinking about your spending rate or anything else to fund those long-term care costs. And also make sure that you're being realistic about how much you'll need in that long-term-care kitty, if you are in fact deciding to self-fund.
Stipp: For a lot of folks who do need long-term care, it could be likely that it's because of some cognitive impairment that happens in older age. So, what do you need to think about there to make sure that your plan is in place?
Benz: So, in addition to making sure that you are setting money aside or insuring against these costs, I think everyone getting close to retirement or in retirement needs to think about the possibility of cognitive decline, because it's not something that you will necessarily be able to deal with once you are in fact cognitively impaired. So, it's important to think about that: We've often talked about simplifying investment accounts, documenting what you have, sharing that information with a trusted loved one, or perhaps identifying a financial advisor to help you oversee your investment plan as the years go by.
I think it's really important even if your plan is for your spouse to be handed off to an advisor if you're unable to manage your financial affairs, it's important if you're the financially savvy partner in your household to identify that person in advance, make sure that your spouse or partner meets that person, is comfortable with him or her, and form that relationship before it's actually required. Maybe you can pay that person on a per-engagement basis or an hourly basis in those years when you're still comfortable managing your investment plan yourself, but definitely get that relationship going before you actually need it in a very direct way.
Stipp: And you may also put up some safeguards or guardrails against financial fraud.
Benz: This is a big issue. There has certainly been a lot of research that has shown that certainly seniors who are cognitively impaired can be big targets for financial fraudsters. So, it's important to make sure that you're practicing good habits in terms of shredding sensitive documents. I always say to just try to reduce the paper flow coming into your house. If you're receiving online statements, make sure that you are updating all your security software on a regular basis. Just make sure that you are putting up good defenses against financial fraud, which is unfortunately a very big and growing problem in the elderly population.
Stipp: Christine, some very key risks but also some excellent ways to mitigate them for retirees. Thanks for joining me.
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.