There are risks everyone must consider in retirement and different strategies to address each of these. The appropriate strategy for you will depend on the type of retirement plan your employer offers. For a more comprehensive list of retirement risks, we recommend this article by the Society of Actuaries.
Longevity risk is the risk of a retiree outliving his or her retirement benefits. Traditional defined benefit plans provide annuities that give members monthly income for life. Under a traditional defined benefit plan, retirees do not need to worry about longevity risk. Under a defined contribution plan, members hold separate accounts and usually receive a lump-sum payment when they retire. They then have several options to spread their benefits over their lifetime, including following the “4% rule” or buying an annuity.
The 4% rule is a popular self-management strategy for retirement funds that is recommended by many financial advisors; it is a possible means for employees to manage their own longevity risk. Under this rule, a retiree draws 4% of his or her retirement account value during the first year of retirement and then adjusts the withdrawal rate for inflation in subsequent years.
Example: If a retiree’s 401(k) fund has $100,000 at retirement, then he or she withdraws $4,000 (.04 X 100,000) from the fund during the first year of retirement. If inflation is 3% the following year, then the retiree withdraws $4,120 ($4,000 + [4,000 * .03]) from the remaining balance in the second year.
On average, you’ll need to save a lot more money up front if you follow the “4% rule” and you will not completely reduce the risk of outliving your savings.
Buying an annuity is a less expensive option than following spending plans like the “4% rule”. If you buy an immediate lifetime annuity (usually purchased from an insurance company), you are guaranteed payments for life.
Insurance companies and financial advisors offer a variety of products called annuities. Some of these protect against longevity risk and some do not. Before buying any such product, you should consult a financial advisor who does not stand to gain a commission by selling you an annuity product.
Investment risk is the risk that you will have a lower than expected rate of return and possibly lose money in your investments. Different types of investments carry different levels of risks (stocks have greater risk than Treasury bonds); this is why it is important to diversify your portfolio.
Despite the recent economic downturn, those who invest in the stock market in the long term can still benefit from positive returns. The previous year has been difficult but history has shown that those who invest over the long term (20+ years) can have positive returns on average (see Figure 2). If you are investing for retirement, it is best to gradually move your money away from stocks into less riskier assets (e.g. bonds) as you get closer to retirement.
Inflation risk is the risk that the inflation rate will increase during your retirement, reducing the purchasing power of your retirement assets.
Example: Suppose George receives a $100 dollar bill on January 1, 2009, loses it between his couch cushions and doesn’t find it until he’s looking for his car keys on January 1, 2010. If George had spent the money a year ago, it would have had the purchasing power of $100. But if the inflation rate for 2009 was 3%, then the same $100 bill has the purchasing power of $97 in 2009. Since the price of goods has gone up, George cannot purchase as much with his $100 in 2010 as he could have in 2009.
Over time, inflation can have a major impact on the purchasing power of your retirement assets, but there are different ways to address this. If you receive payments from a defined benefit plan, then your plan sponsor may use Cost of Living Adjustments (COLAs) to help preserve the purchasing power of your retirement income. If you have a 401(k) plan, you can invest in Treasury Inflation Protected Securities (TIPS) or use other savings vehicles that will produce a rate of return greater than or equal to the inflation rate.