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Your portfolio balance has gotten larger and larger. You've crunched the numbers, conferred with your spouse and family, and set a tentative date. You think you might be ready to retire.
But before you pull the rip cord and start relying on your portfolio--rather than your salary--for living expenses, it's wise to make sure you're not missing anything on the financial front.
Here are some of trouble spots that have the potential to catch retirees off guard.
Not surprisingly, individuals have a tendency to retire when the market is up and their portfolios are enlarged. Indeed, in a recent survey by the Employee Benefits Research Institute (EBRI), 2 of 3 workers said that they were somewhat or very confident in their ability to retire. Yet periods of enlarged portfolio balances often coincide with heightened market valuations--and heightened levels of risk. Research conducted in 2012 by Rui Yao and Eric Park demonstrated that even though people often retire after periods of strong market returns, that, somewhat counterintuitively, tends to reduce their portfolios' sustainability rather than enhance it. Today, prospective retirees have to contend with the one-two punch of not-cheap equity valuations and very low yields on bonds.
Does that mean that you should park your whole portfolio in cash, or worse yet, defer retirement until after stock prices have already fallen (and run the risk that you'll be too spooked to retire at all)? No. But it does mean that you should earmark enough of your retirement portfolio for safe securities, which you can draw from to tide you through periods of equity- or bond-market weakness. You can also plan to reduce your portfolio spending in periods of extreme volatility. This article discusses the possibility that new retirees will encounter volatility in the early innings of their retirements, and what they should do if that’s the case.
It's tempting to not get too worked up about inflation and its impact on your retirement plan. After all, CPI has been running at a fairly benign level of less than 2% for the better part of a decade. And in any case, how could such innocuous little numbers like 2% or 3% make a big difference in the success or failure of your plan?
One of the key reasons you should care about inflation in the first place is that if you've staked a decent share of your portfolio in fixed-rate investments like cash or bonds--as is only prudent to do leading up to and in retirement--higher prices on goods and services you need to buy will erode the purchasing power of your returns on those investments. Another way to think about it is if you've staked more of your assets in conservative investments as retirement approaches, that lowers the absolute return you're apt to earn on your portfolio, and inflation could take a big bite out of your earnings. If you're lucky to earn 5% on your money, you sure as heck wouldn't want to give up 60% of that gain, as you'd effectively do if inflation runs at 3% during your retirement years.
There's also the fact that inflation has been kicking up a little bit recently, and, more importantly, that inflation for older adults has tended to run higher than the general inflation rate. In large that's part because healthcare-related expenses are a bigger share of the average older adult's total household outlays, and those costs have been running about 70% higher than the general inflation rate. Financial advisor Carolyn McClanahan, an M.D. who specializes on the intersection between healthcare and financial planning, has argued that the current rate of healthcare inflation is not sustainable. But for now, at least, they're a force to be reckoned with.
You can defend against inflation in a couple of key ways. One is to embed direct inflation hedges like inflation-protected bonds in the bond portion of your portfolio; when inflation goes up, you get a little raise on the principal or interest coming from the bonds. But don’t stop there. At the risk of stating the obvious, those inflation-protected bonds only confer inflation protection upon the portion of the portfolio you've invested in them. Moreover, because the inflation adjustments you receive on those bonds are keyed off of the general inflation rate, not the inflation rate you personally experience, they may not reflect your actual purchasing experience. If you have a lot of healthcare expenses, for example, that will tend to push your personal inflation rate above the general inflation rate. I think the best way to help address that issue is to simply hold a healthy share of your portfolio in stocks throughout retirement. While by no means a direct inflation hedge--if inflation goes up by 3% in a given year, your stock portfolio is by no means likely to return the same--over time equities have provided the best long-run shot at out-earning inflation.
Your portfolio balance might look comfortingly large. But unfortunately, it's probably not all your money. If you have assets in tax-deferred accounts, you'll owe ordinary income tax on the bulk of your withdrawals; you may owe state income taxes on those distributions, too. After taxes, your withdrawals could shrink by a fourth or even more. The government also has a claim on any appreciation you've enjoyed in your taxable accounts and haven't yet payed taxes on. Those levies can take a bite out of your take-home return.
You'll face other taxes in retirement, too. Social Security is taxed for households with what's called "provisional income" (your adjusted gross income plus nontaxable interest plus 50% of your Social Security) above a certain level. And for retirees who live in areas with high property taxes, those bills can be right near the top of many household budgets; that's even worse when you consider that the deduction for state, local, and property taxes is now capped at $10,000 per year.
Not surprisingly, there aren't many foolproof ways to reduce your in-retirement tax bills. Converting some of your traditional IRA/401(k) balances to Roth is a way to reduce taxes down the line, but the trade-off is that you'll pay taxes when you do the conversion. One way to manage that tax hit is to convert in years when your tax rate is at a low ebb. (Vanguard's retirement guru Maria Bruno has pointed out that the post-retirement, pre-required minimum distribution years are an ideal time to do so.) If you're stuck with a high property tax bill and would like to stay in your home rather than relocate to a lower-tax part of the country, just make sure you're taking advantage of any property-tax relief that your municipality is offering to seniors or people on fixed incomes.
Healthcare/Long-Term Care Expenses
Here's your depressing statistic of the day: Fidelity estimates the average 65-year-old couple will spend $285,000 on healthcare expenses throughout their retirement years. Many people assume that once they're covered by Medicare, they're home free, but retirees confront an array of healthcare expenses even when they're under the Medicare umbrella: supplemental insurance policy premiums, prescription drug costs, and copayments, to name a few. More depressing still, the Fidelity number doesn't include long-term care expenses, so if those arise, they'll take a significant chunk out of your portfolio.
There's no way to avoid at least some of these costs, but at a minimum you should factor a supplemental insurance policy and prescription drug coverage into your in-retirement household budget. It's also a good idea to re-shop your Medicare coverage each open-enrollment season.
How to plan for long-term care expenses is the most vexing question facing most pre-retiree households. Premiums on pure long-term care policies have been marching upward for the past several decades, putting pressure on existing policyholders and would-be buyers. Meanwhile, actual long-term care costs have also been inflating at a higher rate than the general inflation rate, increasing the burden for retirees who expect to self-fund for such expenses. Hybrid long-term care/life and long-term care/annuity policies have some appealing attributes, but they're not without drawbacks, as discussed here. There are no easy answers, but it's important to go in with your eyes wide open to what the costs might be, should you incur them.
Even if you've calibrated your budget to a T and taken a closer look at how it might change in retirement versus when you were working, it's still wise to set aside cash to cover unanticipated expenses. While your emergency fund in retirement needn't be as large as it was when you were working, holding enough liquid assets to cover those lumpier outlays--whether a new roof or a big dental bill--is a best practice in retirement. You might even take the next step of forecasting those periodic, large, off-budget outlays and incorporating them into your spending plan, as discussed here. Doing so will help ensure that they don't throw you off of your planned withdrawal rate.
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.