Retirement Risks: What to Expect and How to Prepare

It’s no secret that retirement can be a risky period for investors.

For many pre-retirees and retirees alike, the thought of retirement brings with it a sense of anxiety and worry.

Leaving a life with a steady job and a comfortable paycheck is nerve-racking because that all goes away when you retire.

You’ll face a multitude of retirement risks throughout your journey. And, if you don’t have a plan to counter those risks, you may run out of money, pay too much in taxes, or both.

The good news is that many of the retirement risks you’ll face can be mitigated with the right strategies and knowing how to avoid them is essential for a secure and comfortable retirement.

Here are nine retirement risks that you need to be aware of as you plan for your next chapter in life.

  1. Inflation Risk in Retirement
  2. Market Risk in Retirement
  3. Interest Rate Risk in Retirement
  4. Behavioral Risk in Retirement
  5. Sequence of Return Risk in Retirement
  6. Tax Risk in Retirement
  7. Liquidity Risk in Retirement
  8. Opportunity Cost Risk in Retirement
  9. Longevity Risk in Retirement

You’ll also learn about strategies we often use with clients that can help mitigate retirement risks and strengthen your retirement income planning.

Inflation Risk in Retirement

Inflation risk is the danger that your savings and investments will not keep up with the rising cost of living, resulting in a decline in your purchasing power. Said another way, your current living expenses will increase over time because of inflation.

For retirees who typically have a fixed income, inflation can be a major threat to your financial security.

Inflation is a silent killer that can erode the value of your savings over time, and it can be very difficult to predict how high it will go.

There have been several periods in United States history where inflation was especially high thus making it difficult for retirees to keep their purchasing power at pace with the rising cost of goods.

Some of the most notable examples are:

  • The late 1970s, when inflation reached more than 14% annually
  • The early 1980s, when it peaked at more than 13%
  • The late 1990s, when it reached more than 4%

Each of these periods presented unique challenges for retirees and investors.

There are a few things you can do to help protect yourself from inflation risk:

  • Make sure you have a diversified portfolio, with exposure to different asset classes including stocks and real estate.
  • Invest in assets that have a history of outpacing inflation, such as real estate or value stocks.
  • Consider using inflation-protected investments, such as TIPS or I Bonds as a portion of your fixed income.
  • Utilize a health savings account to help pay for rising health care costs and health care expenses.
  • Optimize your retirement account withdrawal strategy to help lower taxes.

Market Risk in Retirement

Market risk refers to the possibility that the value of your investments will fall due to factors such as economic recession or political instability. This is a particular concern for retirees, who may not have time to wait for their investments to recover if they lose money.

Since the 1950s, there have been several major stock market crashes that have caused significant losses for investors.

The most recent example of a sudden market downturn was the stock market crash of 2022 which resulted in the stock market crashing by more than 20% from peak to trough.

Other notable examples include the crash of 2008, which led to the Great Recession, and the dot-com bubble burst of 2000, which caused the NASDAQ to lose more than 78% of its value.

Each of these crashes had a unique set of causes, but they all resulted in significant losses for investors.

If you’re planning on retiring in the near future, it’s important to be aware of these risks and take steps to protect yourself from them.

To help manage your market risk, consider the following:

  • Understand your risk tolerance so you can properly allocate the correct amount of investments across stocks, bonds, and cash.
  • Implement opportunistic portfolio rebalancing. (Buy low/Sell high)
  • Properly diversifying your retirement portfolio across fixed-income, U.S. companies, and non-U.S. companies.
  • Avoid owning more than 5% of your portfolio in any single stock holding.
  • Avoid short-term trading strategies.
  • Avoid trying to time when to get in and out of the stock market.

Interest Rate Risk in Retirement

Interest rate risk is the danger that rising interest rates will cause the value of your fixed-income investments to decline.

When interest rates rise, the prices of bonds fall. This is because investors can get a higher return from investing in new bonds that are paying a higher rate. The longer the term of the bond the more pronounced the volatility can be.

One of the worst bond markets in history occurred in the early 1980s when interest rates reached their highest levels in decades.

This caused the value of bonds to plummet, and many investors lost significant amounts of money if they sold their bonds before they matured.

Here are several strategies to help combat interest rate risk in retirement:

  • Consider investing a portion of your portfolio in bonds with short-term maturities between 1 to 3 years.
  • Maintain fixed-rate loans and mortgages if any.
  • Maintain adequate cash reserves of 1 to 2 years of your total expenses.
  • If possible, avoid moving during periods of rising rates if you’ll need a mortgage to finance the purchase.

Behavioral Risk in Retirement

Behavioral finance is a field of study that combines the principles of economics and psychology to gain an understanding of how people make financial decisions. It focuses on the psychological factors that influence decision-making, such as emotions, risk preferences, and cognitive biases.

The concept of behavioral finance was popularized by Nobel Prize-winning behavioral economist Daniel Kahneman in his 2002 book Thinking Fast and Slow. In it, he suggested that investors are prone to making irrational decisions when it comes to investing due to their inherent biases, particularly when they feel overwhelmed or uncertain.

Behavioral finance recognizes that emotions can play a huge role in how people invest their money. Fear, greed, overconfidence, and regret are all common emotional states that can shape investor behavior. This is often referred to as the “emotion cycle” of investing, which has proven to be one of the major risks for retirees.

Another important factor for retirees to consider is a cognitive bias. Cognitive bias occurs when people let their preconceived notions or beliefs hinder their ability to make rational investment decisions. This could be anything from holding onto losing stocks too long out of hope you will turn around, to become overly focused on short-term market fluctuations rather than taking a long-term view of your retirement portfolio’s performance.

By recognizing these biases and understanding the risks of your behavior we can take steps to counteract them, such as seeking out objective advice from a qualified financial advisor when necessary and having a personalized retirement income plan that helps you maintain focus on what you can control.

Ultimately, while there is no substitute for doing the research before entering retirement investments, it’s also important for retirees to be aware of how behavioral finance risks can affect their investments as well.

Here are several actions you can take to help better manage behavioral risks in retirement:

  • Hire a financial advisor who can help remove emotion from your thought process
  • Create a plan to help you maintain focus when emotions are high
  • Learn more about how markets work to help you become a more disciplined investor

Sequence of Return Risk in Retirement

The sequence of return risk is the danger that a retiree will experience negative returns in the early years of retirement, which can potentially lead you toward running out of money later in life.

For example, if someone were to retire in 2000 and heavily invested in stocks, they would have experienced a significant decline in the value of their investments due to the dot com crash. This drop in value would have been further amplified by any withdrawals they made during this period, as each withdrawal would have decreased their portfolio even more. The combination of these negative returns along with withdrawals could mean that the individual’s portfolio may not last them through their retirement years.

An example of a common mistake that investors make as it relates to sequence of return risk is when a retiree has multiple accounts with different types of investments and they withdraw from one account before another, regardless of the market performance. For instance, if an individual had both stocks and bonds within their retirement portfolio but withdrew from only the stock portion during a down market year, it could potentially mean even greater losses for them as stocks tend to be more volatile than bonds.

Retirees need to be aware of the sequence of return risk and take steps to protect themselves from it.

Potential strategies to help mitigate the sequence of return risk in retirement may include:

  • Implement strategies that create guaranteed income to cover your fixed expenses and utilize your retirement savings for variable expenses for which you have more control over the timing of those expenses.
  • Properly diversify your retirement savings and investment assets using mutual funds or exchange-traded funds (ETFs).
  • Determine the optimal spending strategy and order of withdrawals across your account types.
  • Be diligent about which investments you draw from first during up and down stock markets.
  • Maintain 1 to 2 years of cash on hand to cover expenses to help reduce risks associated with a sequence of return risk.
  • By withdrawing from bonds or fixed-income investments rather than from stock positions when stocks are down — an investor may help prevent large losses due to a single type of investment experiencing a downturn.
  • Retirees need to be aware of the risks associated with withdrawing their money during negative market years and take steps to protect themselves from running out of money later on in life.

Tax Risk in Retirement

Tax risks in retirement usually come in two forms: not having enough money to pay taxes and inadvertently increasing your tax bill.

We’ve found that retirees rarely integrate their tax plan with their investment plan, thus creating costly problems in the near term and later in retirement.

The good news is that with proper tax planning, you can help manage tax risk in retirement and have more money left over to spend on yourself and your loved ones.

There are many strategies you can implement to help minimize the chances of not having enough money to pay taxes and to help reduce your total income tax bill.

First, you’ll want to plan to make sure that you have adequate cash on hand and a healthy balance in your taxable accounts such as brokerage or trusts. Not having proper tax diversification across different account types in retirement is one of the biggest mistakes we see retirees make.

To help avoid overpaying taxes in retirement, you’ll want to incorporate tax bracket management.

Tax bracket management is the process of strategically withdrawing money from your retirement accounts at the right time to avoid pushing your income unnecessarily into higher tax brackets while also taking advantage of lower tax brackets.

Your overall tax bracket management approach can be managed using the following strategies:

  • Order of withdrawal strategies
  • Tax-loss harvesting
  • Tax-gain harvesting
  • Roth conversion strategies
  • Qualified charitable distributions
  • Charitable bunching
  • Strategic qualified account withdrawals
  • Delay filing for social security from the social security administration
  • Properly save across taxable, tax-deferred, and tax-free accounts well before retirement
  • It’s also important to be aware of the many deductions and credits available to retirees, so you can take advantage of them when filing your taxes.

By incorporating many of the strategies above, you substantially boost the likelihood of paying less in taxes and being prepared for changes to future tax laws.

Liquidity Risk in Retirement

Liquidity risk in retirement is the possibility that you will not have enough money available to cover your expenses. This can happen when you don’t have enough cash on hand, when investments are difficult to sell or when you need to access money quickly and can’t.

For example, imagine that you have found a new home that you want to purchase so you can downsize in retirement, but you don’t have enough liquidity to submit a strong offer on the house. This could put you in the difficult position of having to sell investments and incur sizable taxation at the same time.

If you plan accordingly, liquidity risk can be reduced.

Here are several strategies you may consider to help reduce liquidity risk:

  • Maintain a diversified portfolio of assets that include different types of investments such as government bonds. This will allow you more flexibility in being able to access investments that may not have significant capital gains.
  • Keep an adequate amount of cash on hand to cover unexpected costs.
  • Plan ahead and know how much money you’ll need each year in retirement through detailed cash flow planning.
  • Consider taking distributions slowly over time rather than all at once.
  • Harvest losses in your portfolio in years where stocks are down to help offset future gains in years where you may have a large liquidity need.
  • Open an equity line of credit on your home.

Opportunity Cost Risk in Retirement

Opportunity cost risk in retirement is the potential for lost earnings due to missed investment opportunities.

Opportunity cost is the cost of not taking an action or investing in a particular asset. It’s the idea that any money, time, or resources used in one way means they can’t be used elsewhere. This is a critical concept to understand when it comes to retirement planning, as every decision has potential risks and rewards associated with it.

As an example, this can happen when you choose to sit on the sidelines in cash because you are nervous about stock markets.

Another example may include the decision to purchase long-term care insurance instead of investing in the premium payments in the market.

Opportunity costs are often quite hard to measure, as you’re essentially comparing one action to another without knowing what would have happened if you had pursued the other option. However, this type of analysis can be incredibly beneficial when it comes to making decisions about your retirement portfolio.

For example, if you decide not to invest in a certain stock or mutual fund due to financial risks associated with it, you may miss out on a potentially lucrative investment opportunity and suffer from lost earnings as a result. On the other hand, if you decide to invest in something that turns out to be riskier than expected, you could end up taking losses that could have been avoided by making different decisions.

It’s worth noting that opportunity cost risks don’t just apply to investments.

Even seemingly small lifestyle choices – like choosing where and how much of your income goes towards housing – can have drastic implications on your retirement savings in the long run. For instance, buying an expensive home could leave you with less money for investing and growing your wealth over time.

Ultimately, understanding opportunity costs and incorporating them into your retirement planning process can help ensure that you make decisions that lead to maximum growth in your savings over time – and minimize risks associated with missed opportunities down the line.

A sound retirement income plan should incorporate scenarios that help you understand the tradeoffs of making certain decisions.

Longevity Risk in Retirement

Longevity risk in retirement is the risk of outliving your savings and investments. This can have a huge impact on a retiree’s ability to stay financially secure throughout their golden years.

Living too long can pose a risk to your financial security in retirement because you’ll need to make your money last longer.

When planning for retirement, most people underestimate the risks associated with living longer than expected and having to stretch their savings over more years. This is because life expectancy and life span increase as medical science advances, making it even more difficult to determine how long you may need your retirement funds to last.

Unfortunately, the majority of retirees don’t have an adequate plan in place that caters to the risks of living too long. The result is that many retirees find themselves struggling financially when they outlive their savings or investments.

There are several strategies you can use to help protect yourself against longevity risks, including:

  • Create cash flow projections in retirement: This is a crucial part of financial planning and can help ensure that you have a steady stream of income to cover your expenses. One way to do this is by developing a budget that accounts for your current income, as well as any potential risks associated with living longer than expected.
  • Delay your retirement age: Working longer and potentially moving your retirement age from age 62 to age 65 as an example, can help reduce the amount of money you have to withdraw from your portfolio.
  • Invest in annuities: An annuity provides a fixed income stream for the rest of your life and includes some form of the death benefit if you pass away before it runs out.
  • Maximize Social Security benefits: Knowing exactly when to claim Social Security can make a big difference in maximizing benefits over time, ensuring that you receive higher monthly payments for as long as possible. Be sure to log in to your account to verify your potential benefits through the social security administration and run a social security analysis to maximize your benefits.
  • Utilize Roth IRA accounts: A Roth IRA account allows you the option of withdrawing contributions and earnings without any taxes or penalties once you turn 59 1/2 years old – helping ensure that you have better tax control over your money in retirement.
  • Utilize portfolio rebalancing strategies: Rebalancing helps keep portfolios aligned with your risk tolerance and can reduce risk by selling off investments that have grown too large and buying back investments that have declined in value. This may help protect against market volatility without sacrificing returns over time.

Ultimately, it’s important for you to understand the risks associated with living too long so you can develop an appropriate plan that will help you remain financially secure throughout your golden years – no matter how long those years may be!

Conclusion

If you are nearing retirement or currently retired, you should make sure that you are familiar with the risks associated with retirement and develop a plan that caters to your specific needs.

If you don’t identify the risks in retirement in advance, you won’t be able to properly plan. As a result, you’ll likely end up making costly mistakes that could impact your savings and investment assets, your retirement assets, your tax bill, and your ability to make your money last in retirement.

Retirement income planning can be a powerful step to help thwart the retirement risks you will face.

Do you need help with your retirement income planning? We can help.

Contact us today for a free consultation.

We advise clients across the United States.