Combating Financial Risks

What are the risks you face in living a comfortable retirement? And what can you do to combat them? A single-premium annuity and wisely managed Social Security are two remedies. First, though, you need to scope out the risks that can bring you to grief.

Imagine how financial planning would be different if the sole focus was on accumulation of wealth, and you didn’t need to worry about risk. You would not need insurance of any kind. Disability and life insurance would just be unnecessary expenses. Individuals would borrow as much as possible to leverage their highly aggressive and concentrated investment portfolios. 

Thankfully, most people wisely protect themselves from unwelcome outcomes by buying insurance, maintaining an emergency cash reserve and diversifying their investments. However, most people tend to be under-protected from some of the key risks of retirement.

For a 62-year-old entering retirement, the financial risks are very different from a 42-year-old supporting a family. Two of the most important financial risks likely facing the 42-year-old are death and disability, which diminishes a breadwinner’s earnings – and harms family finances and children’s upbringing. As a result, the family breadwinner commonly purchases insurance to cover those risks.

Those same risks, though, are typically not financial risks for the 62-year-old. The retiree likely has no need for life insurance or disability insurance. Instead, the risks have shifted and the following become three of the most important:

Inflation Risk. During the accumulation phase of life, most people have income or salary, which adjusts annually for inflation. They also tend to have more invested in stocks, which act as an inflation hedge. Finally, they usually have a fixed-rate mortgage, which acts as an inflation hedge – people can pay off the debt with cheaper dollars if significant inflation occurs.

Alternatively, retirees tend not to have any of this inflation protection, aside from Social Security, which is pegged to the Consumer Price Index. Still, Social Security is unlikely to cover all your retirement financial needs, although it is a vital bulwark for retiree income. So the threat of rising inflation and more expensive goods or services poses a serious risk.

Longevity Risk. What if you outlive your retirement resources? According to an HSBC study, Americans on average have savings that will pay for only two-thirds of their expected retiree years. This is perhaps the greatest financial risk for many retirees.

Sequence of Returns Risk. Individuals who retired in 1999 or 2007 are likely well aware of this risk. Those years were right before the two of the most horrific stock market slides in history. Specifically, weak equity markets early in retirement pose far greater problems for retirees than weak ones later on.

Is there a single strategy to mitigate these risks – and what does it look like? The best answer: a single premium inflation-adjusted annuity from a financially strong provider. This means you pay a lump sum upfront and get an income stream for life. The inflation-adjustments mitigate the risk of higher inflation.

The stable annuity payments reduce the risk of market volatility or getting a bad sequence of returns. Finally, an annuity that pays benefits for a lifetime clearly mitigates the longevity risk. Ideally, you add a strong survivorship feature to this annuity, so if you die first, your spouse is provided for, as well.

This is not a sales pitch for immediate annuities as there are many cases where they are unnecessary or do not make sense, especially when interest rates are low. Moreover, immediate annuities mitigate some of the risks above but they may require sacrificing lifestyle spending. Nevertheless, these annuities can be a useful tool in mitigating retirement risks.

In the next article, I’ll spell out how to maximize your Social Security.

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Jason Lina, CFA, CFP is Lead Advisor at Resource Planning Group Ltd. In Atlanta. Website: http://www.rpgplanner.com

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