Strategies to keep you in control
KEY TAKEAWAYS
Diversify your tax profile now to prepare for the unknown of future tax rates.
Keep the right amount of cash on hand and maintain an appropriate stock allocation in your investment strategy to combat inflation.
Consider Health Savings Accounts & Long-Term Care insurance to address future medical costs.
Establish durable powers of attorney for healthcare and property while you still have strong cognitive ability.
Plan for a longer than expected retirement period and account for which sources your retirement spending needs will come from.
There are several inherent risks with retirement that have nothing to do with your investment strategy:
Taxes,
Inflation,
Medical expenses/long-term care,
Cognitive decline, and
Longevity
While all these risks are beyond your control, identifying them and having a plan for them can help protect the nest egg that you have worked your entire life to build.
Here is a look at the five retirement risks that everyone must face and potential strategies to address them.
1. Taxes
If you’re like most pre-retirees (and retirees) in America, the majority of your assets are pre-tax, meaning that they have not been taxed yet. Pensions, social security benefits, and your pre-tax contributions to 401(k), 403(b), and/or 457 Plans will all be subject to ordinary income tax rates.
One of the biggest risks in retirement is not knowing what income tax rates will be in the future. We don’t know what income tax rates will be in three months, let alone in 15 years. If income tax rates go up and most of your assets are pre-tax, you have no choice but to have more of your dollars go towards paying taxes instead of supporting your living needs. Taking that a step further, if you are withdrawing during a year when the market is down AND tax rates are high, your long-term financial health might be at risk. The best way to mitigate this risk is by having a diversified tax profile.
Pre-Tax: Assets that have not been taxed and are growing tax-deferred.
Roth: Assets that have already been taxed and are growing tax-free.
Taxable: Assets in brokerage and trust accounts that are only taxed upon the sale of an investment, and potentially at preferred tax rates.
Tax-free assets are extremely valuable to have, and there are several ways to build them depending on your age and income. The sooner you start, the bigger your tax-free balance can be.
2. Rising inflation
Inflation reduces your spending power and can have a big impact on a 30-year (or longer) retirement. There are two things that you can do to combat inflation – 1) keep the right amount of cash on hand and, 2) maintain an appropriate stock allocation in your investment strategy.
To determine how much cash to keep on hand, you will want to consider:
Emergency fund: 3-6 months of spending needs
Near-term cash outflows: down payments, wedding, tuition, tax payments
If nearing retirement: additional cash to reduce portfolio withdrawals.
Other planning opportunities: Roth conversions, for example.
Once you determine the amount of cash to keep on hand, maintain that balance in a high yield savings account, where you can earn around 0.50% in interest. While it may not seem like much, it is still 50x more than you would earn in most savings accounts.
High yield savings accounts are best for your cash balances, but they will never keep up with inflation. The best way to maintain your long-term purchasing power is with the right investment strategy. Too many people make the mistake of owning very little to no stocks once they retire, but the truth is, you can’t afford not to own stocks. You should have several years of your spending needs accounted for and invested in diversified bonds, while the rest of your diversified stock strategy generates the returns you need to sustain your lifestyle for the long-term.
3. Medical costs and long-term care
One implication of living longer is increased health care costs. Research shows that the average healthy 65-year-old couple can expect to spend more than $300,000 on health care alone during retirement. While Medicare covers many medical expenses you are likely to face, it does not cover everything, including the cost of long-term care.
Using a Health Savings Account (HSA) is ideal when planning for future medical expenses. In fact, we believe that an HSA is the best savings vehicle out there. If you are in a high-deductible health plan, you can make pre-tax contributions to an HSA, and have those dollars grow tax-free as long as they are used for medical expenses. It’s the only account that exists where you can potentially NEVER pay taxes.
Long-term care is another consideration that comes into play when you need assistance for daily activities, like eating, bathing, or dressing. This type of care can be provided at home or at an assisted living facility, like a nursing home. Those age 65 and older have a 70% chance of needing some form of long-term care as they age.
Even if you do not anticipate needing long-term care anytime soon, it may be worth evaluating long-term care insurance now in case you need these services in the future. There are a few ways to obtain this type of coverage, so take the time to find the right structure for your goals.
4. Cognitive decline
Growing evidence points to the unpleasant reality that our ability to make optimal financial decisions declines with age. While that might be hard for some people to hear and accept, it is a natural part of life, and a risk that, if not properly planned for, can have serious effects on your retirement and legacy.
Who will manage your affairs if you are no longer in an adequate mental state to do so? On the financial side, you will want to appoint an advocate that will assist with paying your bills, managing real estate, and maintaining relationships with banks, financial advisors, CPAs, and any other professionals on your advisory team. For health matters, the person you designate will be responsible for making important decisions about your health care if you are unable to do so.
According to a study done by the Federal Reserve, this is a huge risk and planning opportunity for most of Americans, as only 25% of U.S. adults had appointed an agent under power of attorney. If you do not have durable powers of attorney for healthcare and property in place today, make it a priority to get those established before the end of the year.
5. Length of Retirement
Most people plan on retiring at age 65, but how long are they expecting to live? We commonly find that people underestimate how long they will live, and, as a result, how much they need in retirement savings. The truth is that Americans are living longer now than ever before. Government figures put average life expectancy at about 79 years old, but you could live much longer than that. Planning to live into your 90s is a good first step to reducing the risk of outliving your assets.
Do you plan on retiring at 55? We’re all for it! Just remember, not only will you have to support a longer retirement, but you will also not have social security or Medicare for years. To be eligible for social security and Medicare, you’ll have to wait seven and 10 years, respectively. That means you’ll be relying on your personal savings even more so during that period. It’s not perfect, but you can use the 4% Rule as a gauge for how much you can reasonably withdrawal from your portfolio each year. Too much stress on your portfolio too soon will significantly raise the risk of outliving your assets.
Conclusion
It’s not about getting to retirement, but through retirement. Every retiree will face the above risks as they navigate retirement, and it is how you manage and plan for these risks that will determine how much they impact you. Take the time to plan today so you can approach this next phase of your life with excitement and confidence instead of uncertainty and fear.
Katie Blechschmidt, CFP®
Private Wealth Advisor
