The Hidden Retirement Planning Risk
Building retirement assets is a process that can take decades of hard work and dedication. So it makes sense that many pre-retirees are very concerned about capital preservation, or the strategy of maintaining principal rather than pursuing growth.
But focusing too much on capital preservation can come with a hidden risk: the possibility of actually outliving your assets.
The financial implications of a long retirement
Longevity risk arises when there’s a chance that your asset base won’t be large enough to ensure a lifetime of income. For example, if you have tens of millions of dollars, it’s unlikely you’re concerned about financing your retirement — no matter how long you live or what you’re invested in.
Most people, however, don’t have that kind of money, and as our lifespans expand and our retirements are grow longer, longevity risk is increasingly coming into focus. A 2010 Census report estimated that, based on current trends, one in five Americans would be over age 65 in 2030.1Those retirees may struggle with mitigating longevity risk: a study by the Society of Actuaries discovered that over 50% of Americans underestimate their life expectancies and have time horizons that are too short.2
Part of the difficulty is that, for a single person, estimating life expectancy is a complicated exercise. As the Society of Actuaries study put it, “The individual who retires at age 65 may have a life expectancy of 85, but has some chance of dying at 70 or living to age 100.”
This makes planning all the more difficult, especially when you’re primarily relying on your own savings to finance your retirement. So what do you do?
Considering the solutions
This is where investment strategy can come into play. Why? While the obvious solution may be to control what you can — save more, work longer, and keep your expenses down — it isn’t always so simple.
For example, one’s official retirement date isn’t always a choice. A survey of retirees by Merrill Lynch and Age Wave found that 58% of women and 56% of men retired earlier than planned, many due to health reasons. In other words, for many retirees, drawing down on savings begins sooner than expected.3
Saving more is another solution, and if you’re reading this, you’ve likely made it a priority. But it’s also not always enough — even with a tight budget in retirement. That’s why, while it’s easy to think that your biggest concern should be hanging onto the money you’ve saved, for many people, maintaining asset growth can be an important part of effective retirement saving.
Managing the right risks
If you don’t have a truly large fortune (or even if you do, but you want to maintain the buying power of that fortune), risk management needs to include an assessment of the growth that you’ll require to keep generating income or, at least, to not lose out to inflation.
While this certainly doesn’t apply to everyone, maintaining a level of asset growth could mean taking on more investment risk than you initially imagined. Depending on your financial situation — which includes your overall asset base, other sources of income, goals, and personal risk profile — it might make sense to adjust your allocation with a view towards longer-term growth rather than capital preservation.
This decision is a highly personal one, so make sure to do an honest assessment and think about speaking to an advisor if you need help.
The other aspect of asset growth you should bear in mind is the significance of keeping up with inflation. Historically, prices tend to rise over time: in the US, the long-term average annual inflation rate is 3.28%, though in recent years it’s been lower (last year, inflation was just under 1%).4
Even at low levels, inflation slowly reduces your buying power over time, meaning that you’ll need more dollars to fund the same purchases. In some areas, like healthcare, inflation has outpaced the overall average — an issue that can be especially concerning for retirees.5
In other words, even if you’ve saved entirely enough money to live comfortably in retirement, you need to take inflation into account and plan your allocation and budget accordingly. Depending on your situation, you may need to target a growth rate large enough to at least match inflation, otherwise your purchasing power could fall over the course of what will hopefully be a very long retirement.
How do you balance it all?
Balancing a desire for capital preservation with the need for growth can be tricky, but it is possible.
The first step is to get an understanding of why you’ve chosen a capital preservation strategy and whether it’s the most effective choice for you. If you’re seeking to grow your nest egg or have many years until retirement, it could be worth looking into a more balanced strategy that can help you mitigate longevity risk.
On the other hand, if you’re simply looking to maintain what you have, you might want to consider investing to match or slightly outpace inflation. There are a number of approaches you can take depending on the risks you’re willing to bear — keep in mind that even “safer” investment products come with their own risks.
As with most things in finance, choosing a strategy for your retirement assets is a highly personal exercise. While there is so much we don’t know about how our lives will develop, the right investment plan is one that takes all the risks relevant to you into account, and does whatever possible to mitigate them.