There is a retirement risk that every pre and post retiree may not be seeing right in front of them. I have had the pleasure of working with many different people of different backgrounds, needs and goals over the years that I have been a Financial Advisor. One of the most common reasons that people not only save but seek planning is for their retirement, and why not? No person wants to work for their whole life without the ability to retire and enjoy the fruits of their labor. As a result, we do our best to adhere to some of the basic principles: work hard, save early and watch our spending. However, there are constant forces that we need to account for when we transition into spending the savings, we worked so hard for: inflation, taxes and sequence (order) of returns. Let’s take a look at this through the eyes of a retiree who we will call Jane.
Risk 1: Taxes
Jane worked until she was 65, saved and considered what she will need to spend every month. She put away $500,000 in her retirement savings and has budgeted for expenses of $20,000 per year. Jane understands that if she keeps her expenses at 4% or less of her savings there is a higher likelihood that she will have her money last, and she also feels comfortable with a portfolio allocation that has an average return of 5%. So, the math seems simple to Jane: if I only need 4% of the value of my account and on average, I have a portfolio that returns 5% I will be able to maintain my portfolio value with a slight potential for growth. Unfortunately, this is wrong and all to commonly assumed. The truth of it is that to get the $20,000 from her retirement account after taxes (approx. $5,900 in this case) her total withdrawal starts at $25,900 – this is a 5.18% withdrawal rate from the $500,000 portfolio. Surprised, she still feels confident that although her numbers were slightly off the difference of 0.18% vs her allocations average rate of return would take a long time to be a real threat to her savings…unfortunately this too was a risky assumption and we will explain that next:
Risk 2: Inflation
Costs don’t stay level over time, just think back to what a movie ticket, loaf of bread or soda from a vending machine used to cost in the past as compared to today. The same holds with your expenses over the years in retirement, basic needs expenses have historically gone up just above 2% per year while medical expenses have shown to inflate at just over 5%. This means that within the first 11 years your healthcare costs can be two times the cost from where they had started, while your basic needs expenses can be 27% higher than when you started! This can be a very eye-opening realization for clients that hadn’t accounted for these considerations before coming in to formally plan.
Risk 3: Sequence (Order) of returns
The average return on a portfolio is often taken too literally when planning for a withdrawal strategy. We become hard wired to the average rate of return during our accumulation of investment savings because it can be a way to forecast the potential future value of investments that are not withdrawn from. What this means is that if the money is left to ride out the ups and downs of the markets along the way these peaks and dips will average out over time. However, when we are starting to take from the balance of these savings it can be very important to understand the difference in how these affect our ability to make them last. Having a portfolio downturn in the earlier years can prove to be a larger risk to the ability for your savings to last, in our example with Jane she decided to retire at 65 and will fund her retirement fully for one year until she takes Social Security at her FRA (Full Retirement Age) of 66. Due to all her previous assumptions (not counting for taxes, assuming level costs without inflation) she feels that the extra expense is worth starting on this journey she worked so hard for her whole life. Let’s look at how all these factors together lead to Jane’s retirement running out:
If you haven’t taken these considerations into account, you are not alone. Starting an open conversation with a professional who specializes in retirement planning can help to address these risks as well as provide guidance on what you can do to improve your situation. We are here to help at Coastal Wealth Planners and you can schedule a free consultation or call us at (732)554-1099 to discuss your concerns and needs.