Everyone must consider risks in retirement and different strategies to address each. 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 that you might outlive your 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 by buying an annuity.
The 4% rule is a popular self-management strategy for retirement funds recommended by many financial advisors as a possible means for managing longevity risk. Under this rule, retirees draw 4% of their retirement account value during the first year of retirement then adjust the withdrawal rate for inflation in subsequent years.
Example: If your 401(k) fund has $100,000 at retirement, you withdraw $4,000 (.04 X 100,000) from the fund during your first year of retirement. If inflation is 3% the following year, you withdraw $4,120 ($4,000 + [4,000 * .03]) from the remaining balance in your second year.
On average, you’ll need to save a lot more money up front if you follow the 4% rule; however, this doesn’t guarantee you won’t outlive 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, consult a financial advisor who won’t get a commission by selling you an annuity product.
Investment risk is the risk that you will have a lower than expected rate of return or 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 periodic economic downturns, history has shown that if you invest in the stock market in the long term (20+ years), you can still benefit from positive returns on average (see Figure 2). When 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 2010. Because 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 effect 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.