Five Retirement Planning Blind Spots
Consider these common trouble spots that have the potential to catch you off guard.
Your portfolio balance has gotten larger and larger. You have crunched the numbers, conferred with your spouse and family, and set a tentative date. You think you might be ready to retire. But before you pull the rip cord and start relying on your portfolio—rather than your salary—for living expenses, it is wise to make sure you are not missing anything on the financial front. Here are some of trouble spots that have the potential to catch retirees off guard.
Not surprisingly, individuals have a tendency to retire when the market is up and their portfolios are enlarged. Indeed, in a recent survey by the Center for Retirement Research at Boston College, 2 of 3 workers said that they were somewhat or very confident in their ability to retire. Yet periods of enlarged portfolio balances often coincide with heightened market valuations—and heightened levels of risk. Research conducted in 2012 by Rui Yao and Eric Park demonstrated that even though people often retire after periods of strong market returns, doing so tends to reduce their portfolios’ sustainability rather than enhance it. Today, prospective retirees have to contend with the one-two punch of not-cheap equity valuations and the prospect of rising bond yields. While higher yields will be good news for cash investors, and translate into higher returns for bond investors down the line, they have the potential to depress bond prices in the meantime.
Does that mean that you should park your whole portfolio in cash, or worse yet, defer retirement until after stock and bond prices have already fallen (and run the risk that you will be too spooked to retire at all)? No. But it does mean that you should earmark enough of your retirement portfolio for safe securities, which you can draw from to tide you through periods of equity- or bond-market weakness. You can also plan to reduce your portfolio spending in periods of extreme volatility.
It is tempting to not get too worked up about inflation and its impact on your retirement plan. After all, CPI has been running at a fairly benign level of less than 2% for the better part of a decade. And in any case, how could such innocuous little numbers like 2% or 3% make a big difference in the success or failure of your plan?
One of the key reasons you should care about inflation in the first place is that if you have staked a decent share of your portfolio in fixed-rate investments like cash or bonds—as is only prudent to do leading up to and in retirement—higher prices on goods and services you need to buy will erode the purchasing power of your returns on those investments. Another way to think about it is if you have staked more of your assets in conservative investments as retirement approaches, that lowers the absolute return you are apt to earn on your portfolio, and inflation could take a big bite out of your earnings. If you are lucky to earn 5% on your money, you sure as heck would not want to give up 60% of that gain, as you would effectively do if inflation runs at 3% during your retirement years.
There is also the fact that inflation has been kicking up a little bit recently, and, more importantly, that inflation for older adults has tended to run higher than the general inflation rate. In large that is part because healthcare-related expenses are a bigger share of the average older adult’s total household outlays, and those costs have been running about 70% higher than the general inflation rate.
You can defend against inflation in a couple of key ways. One is to embed direct inflation hedges like inflation-protected bonds in the bond portion of your portfolio; when inflation goes up, you get a little raise on the principal or interest coming from the bonds. But do not stop there. At the risk of stating the obvious, those inflation-protected bonds only confer inflation protection upon the portion of the portfolio you have invested in them. Moreover, because the inflation adjustments you receive on those bonds are keyed off of the general inflation rate, not the inflation rate you personally experience, they may not reflect your actual purchasing experience. If you have a lot of healthcare expenses, for example, that will tend to push your personal inflation rate above the general inflation rate. On way to address this issue is to simply hold a healthy share of your portfolio in stocks throughout retirement. While by no means a direct inflation hedge—if inflation goes up by 3% in a given year, your stock portfolio is by no means likely to return the same—over time equities have provided the best long-run shot at out-earning inflation.
Your portfolio balance might look comfortingly large. But unfortunately, it is probably not all your money. If you have assets in tax-deferred accounts, you will owe ordinary income tax on the bulk of your withdrawals; you may owe state income taxes on those distributions, too. After taxes, your withdrawals could shrink by a fourth or even more. The government also has a claim on any appreciation you have enjoyed in your taxable accounts and have not yet paid taxes on. Those levies can take a bite out of your take-home return.
You will face other taxes in retirement, too. Social Security is taxed for households with what is called “provisional income” (your adjusted gross income plus nontaxable interest plus 50% of your Social Security) above a certain level. And for retirees who live in areas with high property taxes, those bills can be right near the top of many household budgets; that is even worse when you consider that the deduction for state, local, and property taxes is now capped at $10,000 per year.
Not surprisingly, there are not many foolproof ways to reduce your in-retirement tax bills. Converting some of your traditional IRA/401(k) balances to Roth is a way to reduce taxes down the line, but the trade-off is that you will pay taxes when you do the conversion. One way to manage that tax hit is to convert in years when your tax rate is at a low ebb. Perhaps the post-retirement, pre-required minimum distribution years are an ideal time to do so? If you are stuck with a high property tax bill and would like to stay in your home rather than relocate to a lower-tax part of the country, just make sure you are taking advantage of any property-tax relief that your municipality is offering to seniors or people on fixed incomes.
Healthcare/Long-Term Care Expenses
Here is your depressing statistic of the day: One study estimates the average 65-year-old couple will spend $280,000 on healthcare expenses throughout their retirement years. Many people assume that once they are covered by Medicare, they are home free, but retirees confront an array of healthcare expenses even when they are under the Medicare umbrella: supplemental insurance policy premiums, prescription drug costs, and copayments, to name a few. More depressing still, the number above does not include long-term care expenses, so if those arise, they will take a significant chunk out of your portfolio.
There is no way to avoid at least some of these costs, but at a minimum you should factor a supplemental insurance policy and prescription drug coverage into your in-retirement household budget. It is also a good idea to re-shop your Medicare coverage each open-enrollment season.
How to plan for long-term expenses is the most vexing question facing most pre-retiree households. Premiums on pure long-term care policies have been marching upward for the past several decades, putting pressure on existing policyholders and would-be buyers. Meanwhile, actual long-term care costs have also been inflating at a higher rate than the general inflation rate, increasing the burden for retirees who expect to self-fund for such expenses. Hybrid long-term care/life and long-term care/annuity policies have some appealing attributes, but they are not without drawbacks. There are no easy answers, but it is important to go in with your eyes wide open to what the costs might be, should you incur them.
Even if you have calibrated your budget to a T and taken a closer look at how it might change in retirement versus when you were working, it is still wise to set aside cash to cover unanticipated expenses. While your emergency fund in retirement need not be as large as it was when you were working, holding enough liquid assets to cover those lumpier outlays—whether a new roof or a big dental bill—is a best practice in retirement. You might even take the next step of forecasting those periodic, large, off-budget outlays and incorporating them into your spending plan. Doing so will help ensure that they do not throw you off of your planned withdrawal rate.
© Morningstar 2018. All Rights Reserved. Used with permission.
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