What is Retirement Risk? Causes, Types, Managing a Retirement Plan

Coursera 7-Day Trail offer

What is Retirement Risk?

Retirement risk can be defined as the retired person’s probable risks to financial security. Retirement risks can lead to unexpected costs and expenses or a reduced income.

The terms accumulation and decumlation are often associated with retirement. The pre-retirement period is the accumulation phase where an individual earns and saves for his/her future. Once a person retires, decumlation begins and thus, it may be imperative for an individual to estimate the best possible way to spend down assets and receive a lifelong income. The emphasis is on the growth of assets and total returns while planning for retirement. Once an individual retires, the objective is to maintain the current if not a higher standard of living.

The primary financial objective in retirement is to maintain a suitable standard of living post-retirement and one basic approach is to consider longevity as the fundamental risk facing retirees. Retirees may find difficulty in forecasting their retirement duration and so they face a dilemma of wanting to spend as much as possible without overdoing it and triggering financial hardship in old age.

Causes of Retirement Risk

The uncertainty of time of death of an individual is the primary factor that causes the retirement risk. This further gets affected by cultural as well as physiological hazards. In today’s world, the current population has an increased life span and tends to live long after retirement as compared to the older generations.

In the year 1939, a woman who survived till the age of 65 in reasonable health could be anticipated to survive for another 13 years. Today, this life expectancy is more than 20 years. With longer life expectancies, people are also retiring earlier and quit working at earlier ages for several reasons. Financial planning and stability is one such reason, another could be attractive retirement benefits offered by organisations to make place for newer employees.

Types of Retirement Risk

The various types of retirement risk are:

Longevity risk

The longer a retirement lasts, the greater are the chances that other forms of risk will manifest. Enhanced longevity means increased time for another financial crisis, increased time for inflation to compound, increased chances for a costly health problem, etc. Longevity risks can be categorised as follows:

  • Macro/market risk: It helps to recognise the exposure of a retirement plan to macroeconomic factors that are beyond a retiree’s control. Such risks comprise investment volatility related to poor market returns and disadvantageous fluctuations in interest rates. Moreover, public policy is also an issue as unexpected rise in taxes, less social security benefits, or enhanced medical expenses can all affect a spending plan.

    In addition, sequence of returns risk is included in this category. This is a macroeconomic risk with a more personalised impact, as retirees attempting to fund a constant spending stream from a portfolio of volatile assets are especially vulnerable to the specific sequence of market returns experienced in the early part of their retirement.

    Along with the average return, the order of returns also matters. Poor returns early in retirement will result in enhanced spending rate from the portfolio of remaining assets, massively affecting the retiree that will be increasingly difficult to overcome even if there is a subsequent market boom.

  • Inflation risk: For retirees living on a fixed income, rising prices will gradually affect their buying power as products will get more expensive. Even if inflation averages approximately 3 per cent annually, the cost of living doubles in just 23 years.

    In other words, a fixed income will buy half of what it could at the beginning of retirement. Most retirements can last longer than this. The other issue is that the cost-of-living for retirees may increase rapidly than the general population, especially as increasingly expensive healthcare constitutes a larger portion of a retirement budget.

  • Personal spending risk: The basic budget an individual has prepared for retirement will not sufficiently depict the actual costs. Some of the issues here consist of unexpected healthcare and long-term care expenses, the requirement to support other family members, such as adult children or grandchildren, or divorce.

    The death of a spouse is also an important consideration, as social security benefits will reduce by a third to a half, taxes will rise as there are less exemptions, and the surviving spouse may have less knowledge about the particulars of the retirement plan. Fraud and theft are increasing problems for retirees as well, as a real issue that individuals face is decreased cognitive abilities as they age and a number of opportunists will tend to exploit this.

    Retirement risks can also be classified in other ways, such as on the basis of whether they jeopardise the assets of the household balance sheet, or the liability (future spending needs) of the balance sheet. Another approach to classify can be on the basis of whether the risks affect society at a macroeconomic level, or whether they are individual-specific.

Managing a Retirement Plan

Estimating the future income need

This comprises making a prediction of the income needs of an individual post-retirement. For example, an individual who is a government employee staying in a government accommodation may have to plan for costs associated with rental or own house, water, electricity bills, etc. post-retirement. Identification of sources of funds also needs to be carried out in this step.

Accumulation of the required funds

Once the needs and sources are identified, a plan needs to be designed and implemented that will help in accumulation of funds which will be made available in order to provide the required income.

Consumption of funds

Once the source is identified and accumulation planned, the next step involves the duration and method of funds consumption. This requires consideration of the period for which the consumption shall be required and provisioning for the spouse in the case of premature death.

Leave a Reply