Preparing for retirement has changed significantly over the past few decades. Not only are people living longer due to improved health care, but costs have risen dramatically everywhere.
The biggest difference between yesterday’s retiree and today’s retiree is the reduced defined benefit plan – or retirement plan – replaced by defined contribution plans with the ERISA of 1974 (opens in a new tab) establishing the IRA and the Revenue Act of 1978 (opens in a new tab) creation of the 401(k). Studies have shown that pensions are and have been quickly replaced.
As retirees underestimate their longevity, as well as stock market volatility, the likelihood that they will outlive their savings will continue to decline. Appropriate adjustments must be made now before irreparable damage is done.
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Here are the top seven risks that retirees should avoid at all costs, along with tips for dealing with them.
1. Longevity risk
Average life expectancy has fallen from 68.14 years in 1950 to 76.1 years in 2021. With COVID-19, life expectancy has actually decreased by about 1.2 years, but retirees live Longer. The Society of Actuaries (opens in a new tab) estimates that a couple who both reach age 65 have a 50% chance that a surviving spouse will live to age 93 (25% chance that a surviving spouse will live to age 98).
The biggest threat that retirees face is outliving their savings. Although no one knows how long they will live, a 30-year retirement is not nearly as rare compared to past generations.
Pro tip: One way to balance longevity risk is to use a three dollar strategy. The goal is to allocate savings that meet immediate, short-term and long-term needs. The cash is anything in the next five years; the income is what will be needed for 30 years or more; and growth must offset inflation, taxes and future health care costs.
In addition, the Social Security extension of full retirement age to age 70 will provide additional retirement credits of approximately 8% per year, meaning a larger benefit later. For example, if you were born in 1954, your full benefit amount would be at age 66. By deferring until age 70, there would be an additional credit of approximately 32% (8% per year for the next four years).
2. Inflation risk
Inflation is the decrease in purchasing power due to an increase in the price of goods. Since 1914, the average inflation rate has been 3.24% and this figure should remain constant even if the percentages are still relatively high for the next few months. While purchasing power is relevant in retirement, it can be politicized and exaggerated, especially when supply chain issues and price gouging are present.
Pro tip: Use of Treasury Inflation Protected Securities (TIPS) (opens in a new tab) and Series I Bonds (opens in a new tab) are an ideal way to hedge against inflation. In 2022, Series I bond interest rates were 9.62%, but they can only be purchased up to $10,000 per person (up to $20,000 for a couple).
Stay away from speculative or high-risk investments, including private equity, penny stocks, and alternative investments if they don’t fit your risk tolerance.
3. Tax rate risk
The Tax Cuts and Jobs Act 2017 (opens in a new tab) lowered the top tax rate to 37% from 2018, with the majority of the legislation set to expire in 2026, including a lower standard deduction and higher overall tax rates. Whether a retiree is still working or has other forms of taxable income – for example, a pension, bank or annuity interest, short-term capital gains, ordinary dividends, municipal bond income and withdrawals pension schemes – his social security benefits may become taxable.
In 2022, if the combined income is between $25,000 and $34,000 for a single person or between $32,000 and $44,000 for a married couple, up to 50% of their benefits will be included in their tax return. If the combined income is over $34,000 for a single person or over $44,000 for a married couple, up to 85% of their Social Security is taxed.
That’s not even including another retirement tax – Medicare Part B premiums – which are as low as $170.10 a month and as high as $578.30 in 2022. For example, for someone who had a modified adjusted gross income (MAGI) of $150,000 in 2020, their Medicare Part B premiums would be $340.20 per month in 2022. Although this amount will adjust in 2023, it depends on what the MAGI of the individual in 2021.
Pro tip: Converting taxable accounts—for example, traditional IRA or 401(k)—to a Roth in years when income may be lower and using different tax classes should keep you in a lower bracket. Non-qualified annuities (instead of CDs and other banking products) offer tax deferral, which can help with both Social Security taxation and Medicare Part B premiums.
4. Health Care Cost Risk
In addition to long-term care, health care costs, including insurance, Medicare Part B premiums, drug costs, copayments, coinsurance, and deductibles can be expensive. loyalty (opens in a new tab) estimates that an average retired couple turning 65 in 2022 might need about $315,000 in savings (after tax) to cover retirement expenses. If taxable accounts are used, this amount may be higher considering the potential taxes paid.
Unless the US healthcare system changes, costs are inevitable, so it’s ideal to be prepared. Expenses may be lower in retirement for some than for others, but the feeling is that they will most likely increase overall.
Pro tip: Using a Health Savings Account (HSA) offers tax-deductible contributions that grow tax-deferred, and withdrawals are potentially tax-free if used for healthcare expenses. In 2022, the contribution limits are $3,650 for an individual and $7,300 for a family. If you are over 55, there is an additional catch-up contribution of $1,000. In addition, the HSA Financing Qualified Distribution (opens in a new tab) allows for a one-time “trustee-to-trustee” transfer up to an annual contribution (whether individual or family) from the IRA or Roth IRA.
5. Long-term care cost risk
Long-term care costs are by far the most devastating to a retiree’s savings and investment portfolio. With the costs of home health care, assisted living and skilled nursing increasing on average 1.71% to 3.64% or more per year, their current cost could easily double or triple by the time where you will need care.
According to a 2021 Genworth survey on the cost of care (opens in a new tab), home health care in 2021 averaged $61,776, assisted living averaged $54,000, and a semi-private nursing home room averaged $127,538 per person. By 2051, home health care is expected to cost around $149,947, assisted living is expected to cost around $131,072, and a semi-private room in a nursing home is expected to cost around $230,347.
Pro tip: LTC insurance has been the solution recommended by insurance agents and financial advisors for years. The problem is that unsecured premiums allow for other types of “hybrid” policies – for example, life insurance and annuities – with long-term care riders as a viable alternative. Keep in mind that there are different styles of policies, so explore how each works.
6. Lifetime income risk
Until the 1980s, pension plans were a major part of a retiree’s income. According to the Bureau of Labor Statistics (opens in a new tab), this number has dropped considerably for workers in the private sector, to less than 20%. The Pension Rights Center (opens in a new tab) states that only 31% of older Americans have a pension.
Pensions were once the strongest leg of the “three-legged stool,” which also included Social Security and savings, a concept introduced at a Social Security forum in 1949. But today’s retirees hui often have to figure out how to catch up on their own. the most crucial aspect of creating a guaranteed income stream that they won’t outlive.
Pro tip: Not having a guaranteed income for many retirees is a major financial concern. Payout annuities and indexed annuities with income riders focus on the distribution phase in retirement. Using the same investments during the accumulation phase and not reallocating them properly will reduce the likelihood of success that these assets will not last a lifetime.
The SECURE law of 2019 (opens in a new tab) allows employer-sponsored plans, including 401(k)s and government plans such as 403(b)s, to access lifetime income benefit options without having to transfer them to an IRA.
7. Stock market risk
As retirees age, their tolerance for market risk should decrease. Sequence of returns risk is the danger of receiving lower or negative early returns when withdrawals are made in retirement, which can significantly reduce the overall longevity of these assets.
Old-fashioned rules such as the 4% withdrawal rule have been used by retirees since the idea was first published in the Journal of Financial Planning in 1994. It states that a safe withdrawal consisting of 60% stocks and 40% bonds is the perfect way to not run out of money. However, due to low interest rates, this rule has been questioned, with data suggesting it should be lowered from 4% to around 2.95% to 3.3%.
Additionally, there is another ancient rule regarding proper portfolio balance by age known as the Rule of 120 (formerly known as the Rule of 100). He suggests subtracting your age from 120 to get the right percentage of stocks and bonds in your portfolio. For example, if you’re 55, subtracting 55 from 120 means you should have 65% stocks and 35% bonds. The problem with this solution is usually when it allows human nature to interfere.
Pro tip: Don’t use outdated rules to dictate your optimal stock market exposure. Reevaluate your risk tolerance and focus on saving rather than chasing higher returns.
This article was written by and presents the views of our contributing advisor, not Kiplinger’s editorial staff. You can check advisor records with the SEC (opens in a new tab) or with FINRA (opens in a new tab).
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