Mitigations for Retirement-Specific Risks
How do you mitigate retirement-specific risks?
That is, what are your options to plan for future retirement risks?
Last time, we learned about the retirement-specific risks and how mitigatable are they?
Now, we will learn a little about your options for mitigation and how you mitigate the retirement-specific risks.
First, what is risk mitigation?
What is Risk Mitigation?
Risk mitigation involves planning and developing methods and options to reduce threats to meet a specified goal. In retirement planning, you mitigate the known retirement-specific risks. The procedures and options you have to reduce the threat are also risk-specific. The goal is usually the same; to have a wonderful and well-funded retirement.
So, how can you meet that goal by mitigating the retirement-specific risks? You must create a strategy to identify and evaluate risks and consequences inherent to meeting your goal.
So, let’s discuss a strategy to identify and evaluate risks!
A Strategy to Identify and Evaluate Retirement-Specific Risks
Let’s start with the five ways to deal with retirement-specific risk.
The 5 Ways to Deal with Retirement-Specific Risk
The 5 Ways to Deal with Retirement-Specific Risk
Above, you can see the five ways to deal with retirement-specific risks. These are your options. Since we are looking at our options to deal with these risks, we will assume we have chosen not to ignore them entirely.
Ignoring a risk is a perfectly valid option for retirement planning. It, in fact, may be the most common choice! Just don’t plan for Long-Term Care, longevity, or inflation. If they happen, well, I’ll worry about it then.
But if we have chosen not to ignore the retirement-specific risks, what are your five options for dealing with them?
The 5 Ways to Deal with Retirement-Specific Risk
Usually, this is the most expensive option; just avoid exposure at all costs. This can be a little like throwing the baby out with the bathwater, but it is on the spectrum from acceptance all the way to avoidance.
The avoidance strategy means you plan for risk and then actively take steps to avoid it.
You are pretty certain of the results by avoiding the risk, but the timeline is still uncertain. And it is likely to be costly either financially or emotionally.
This is the most common solution. You deal with part of the problem, part of the cost, or part of the risk. Then, you mitigate part of the risk so that you are not financially (or otherwise) devastated if the worst happens.
With the Risk Mitigation strategy, you break down the risk into parts. Cost and timing depend on the goal and the degree of mitigation.
For the retirement-specific risks, risk transference usually means risk pooling and insurance.
Fundamentally, you trade the risk off to a willing third party.
Transference of risk mitigates consequences through contractual guarantees.
With the risk transference strategy, results are contractually guaranteed for certain periods and usually for a defined cost.
Ok, this is essentially ignoring the problem. Accepting the risk is a valid strategy if the avoidance of the risk might outweigh the cost of the risk itself.
Here you just assume the risk. The risk acceptance strategy means you identify and assume the vulnerabilities that the risk entails.
You are responsible for the cost, the time, and the results.
The 5th Way: Your Way
Finally, we deal with the first panel of the above cartoon. After all, you and YOUR PROJECT are why we are here. Your plan will be different from everyone else’s because it comes from your values, dreams, and goals.
How do you limit the damage of retirement-specific risks? What can you control? Is there a way to mitigate part of the damage?
Here, we come to the word “hedge.” As in hedging your bets, rather than in some fancy investment that attempts specifically to address a financial downside based upon future predictions.
For most of us, we will plan to hedge our bets. This is your way, too.
Address some (ignore others), mitigate some, get insurance when you need it, get contractual sources of income if you want it (and can afford it), and avoid what you want and accept what you must.
How you Mitigate/Limit/Control/Hedge your retirement-specific risks depends entirely on what you believe is important to your future goal of a happy retirement.
Risk Limitation to Address Parts of a Retirement-Specific Risk
Risk limitation is a common strategy, and I want to focus it on the retirement-specific risks specifically.
This strategy addresses part of the risk rather than the whole risk. It can address certain aspects of the risk or perhaps set aside a certain dollar amount that might be considered a proportion of the total amount expected due if the risk were to come to fruition.
For example, maybe you are concerned about longevity and running out of money. You have a large IRA, so decide that a QLAC may be just the thing you need. A QLAC is a product that addresses part of the risk rather than the whole risk: if you live to 85 (or whenever you turn the income one), you have a nice (though taxable) source of income kick in late for the rest of your life. This might be right if your expenses increase later in life, but it doesn’t address the many risks raised by longevity and outliving your income specter.
After you list your retirement-specific risks of concern, you can use risk limitation to address any or all of your risks. The idea is to control your risk as best you can via mitigation.
Controlling Retirement-Specific Risks Via Mitigation
So, after we understand our goals and what retirement-specific risks we wish to mitigate, we can move to control those risks.
You use a control strategy when mitigating risks to your specific goals. Take actions to eliminate the impact of the risks by, for instance:
- Controlling risks to cost
- Controlling risk to timeline
- Controlling risk to results
After you think about controlling the risk, you need to consider how you will monitor it over time. You need to monitor the risk, cost, timeline, and results for each control strategy you develop (for each retirement-specific risk).
How to Mitigate a Specific Retirement Risk
So, here is the checklist to mitigate retirement-specific risks.
- -a list of retirement-specific risks
- -ranked by risk based on likelihood (probability of the risk)
- -ranked by cost (chance of ruin)
Then, use a formula to combine risk and cost to develop a force-ranked list of the most like and most costly retirement-specific risks.
-a combined rating for each risk based upon probability and cost
For each risk:
- -an assessment of the current plan
- -a new plan of action
Next, prioritize the risks depending on:
- -High cost and highly likely to occur
- -High cost and less likely to occur
- -Low cost and highly likely to occur
- -Low cost and less likely to occur
Next, determine your options for mitigation. Again, these are:
- Avoid (stop risky activities or turn them over to a third party)
- Reduce (the likelihood of a negative event occurring)
- Accept (live with the risk understanding the cost and probability of occurrence)
The final steps include creating the plan. Then, try to test the plan or stress test it. At least imagine if the worse happens, or the best happens, and then what is halfway between the two?
Residual Risk and Retirement-Specific Risk Factors
Remember to consider residual risk.
You do not need to mitigate each risk fully. But if you do partition off a risk (either in part or in cost), then you can treat each risk as mitigated—part by risk reduction and part, acceptance. Maybe accept the things you cannot change and have the courage to change the things that you can.
The residual risk may be additionally dealt with in any of the five ways above.
Next, I’d like to consider some mitigations for the mitigatable retirement-specific risks.
Mitigations for the Mitigatable Retirement-Specific Risks
So, what are the options to mitigate the mitigatable risks?
There is insurance (risk pooling), where you pay premiums for a third party (insurance company) to share the risk with you, or you can decide to self-fund the risk.
Somewhere in the middle, there are products designed to mitigate specific parts or components of risk. These can either be income-based products (good annuities intended to provide a “personal pension”), or products with a contractual guarantee of participation in the stock market.
On the far other side of the spectrum (or the square, if you use the RISA), you have the probability-based folks. Instead of insurance, they use the risk premium from the stock market and asset allocation to tune risk-reward for future retirement risks.
But take a step back, and you see human capital, other assets (such as real estate and additional cash flowing assets), and other personal sources of income (for instance, pensions and social security claiming decisions) greatly affect your need and ability to mitigate any specific retirement risk.
So, next, let’s take a deep dive into some of the most intractable mitigatable retirement-specific risks to see what we can learn about possible solutions.
Retirement-Specific Risk #1: Unable to Spend after Decades of Saving
Retirement is all about turning assets into income. So how do you convert your assets into money to spend? This is often backward to the beginner retiree. Wait, I have to spend down my assets? After decades of seeing a net worth increase, it is ok to have a net worth drop. Issues that need consideration: long-term cash flow planning, liquidity, spending shocks, and, especially important, move from the accumulation mindset to a de-accumulation one.
There can be several problems if you get stuck in the accumulation mode. Not only do you worry about spending down your assets appropriately, but you can also ignore hedging your bets and covering the other risks out there.
So let’s next talk about the three major risks you face in retirement.
Sequence of Returns Risk
Sequence of Returns Risk may be the largest challenge soon-to-be retirees face. This is because it happens only around the time of retirement. Sequence risk, however, is also easy to plan for!
The last thing you ever want to do is sell your assets when they are low, and I call this the cardinal rule of investing: don’t sell low!
You might be forced to sell low if you retire and the market tanks. This poor sequence of market returns can then plague the rest of your retirement.
Most people don’t retire into a poor sequence, but you have to plan as if you will! Of course, if you don’t, you will be better off than you prepared for the rest of your retirement, but that is better than the alternative!
Longevity is better than the alternative! Some say longevity is the only risk, as all other risks are exacerbated by time. However, longevity is the great multiplier of all other risks. Almost any retirement plan will work out ok if you die shortly after retirement.
But it would be best if you planned to live a long life. And aside from financial issues that are exacerbated by time, there are cognitive and health issues to consider.
Inflation may be a sleeping dragon. Delaying social security until you are 70 and having adequate exposure to equities in the stock market are obvious solutions. But remember what food used to cost you 20 years ago, and remember prices will at least double during your retirement.
There are also inflation-linked fixed securities to consider in your tax-sheltered accounts, and most retirees should consider devoting a portion of their assets to these.
Unfortunately, there are no perfect solutions to the problems caused by inflation. Insurance companies sell some inflation-linked products, but you will often find these too expensive to be worth your time. The insurance companies like to understand exactly what risks they are assuming, and no one can predict what inflation will be in the future!
I deal with inflation during the chapter on longevity. After all, inflation is negative, compounding on your spending ability, and it is only a problem if you live a long life!
Mitigation of Other Retirement Risks
Portfolio risk and asset allocation are important considerations. You must invest your assets wisely and be diversified. Understand your risk tolerance and why asset allocation is important to prevent the one cardinal sin of investing: selling low and locking in losses. The wise pre-retiree wants to be de-risked by about five years before retirement. A total market return mindset is important, as are fixed income and fixed income alternatives. You must be invested appropriately to hedge for the many possible futures.
Taxes in Retirement
Taxes are the largest expense in retirement. Therefore, tax efficiency, tax diversification, and future tax rate policy risk are important considerations at the very base of a comprehensive retirement plan. In addition, partial Roth conversions will be an important consideration for many as a mitigation strategy, as taxes are the only retirement expense you can truly pre-pay.
Illness and Wealth
Health is truly important in all phases of life, but even more so in retirement. When you slow down a bit, you might have a little more time on your hands to improve your health. An exercise and diet plan is as important as anything else in retirement!
Insurance, such as Medicare, supplemental insurance, and Long-Term Care insurance, will challenge you intellectually, as they are among the most difficult considerations in retirement. You can be sure your spending on healthcare will increase in the last few years of a long retirement, so balancing reserves with current spending is important.
No one wants to talk about grey divorce or death of their spouse. Emotions run high in these discussions, but it is important to consider the loss of your spouse. Expenses don’t go down by 50% when there is a loss, but income almost certainly drops at least by the amount of the smaller social security payment.
If you are married, you need to run your retirement plan two more times, one each considering what would happen if a spouse dies early. Of course, this will not deal with the emotional impact of such a tragic event, but the last thing you want to worry about when a spouse dies early is money.
What are Retirement Risks Just Scare Tactics?
There are a few risks that I do not consider worthy of planning for. Which risks are Scare Tactics?
There are a lot of people out there who make money off you. This is the service industry that is the engine behind the American economy.
While we don’t expect services for free, one does need to worry about being taken advantage of. Especially when dealing with money or products designed for retirement. After all, how easy is it to skim off a percent here and a commission there when considering money. You don’t need to be an expert in all things finance, but you do need to understand how a provider of service is being paid. Equally as important, you must understand incentives. There is a great saying by Upton Sinclair which is important to remember: “It is difficult to get a man to understand something when his salary depends on his not understanding it.”
Which risks are scare tactics?
A great example is market volatility. If you watch the financial news media, you would think that a one-day sharp decline in the market is a national tragedy. Unfortunately, a sharp drop in stock prices either in a day or over several months is just the cost of admission for investing. It is to be expected!
Wall Street uses the “risk of market loss” as a strategy intended to manipulate you into fear. On the contrary, volatility is why we invest in the stock market. It is what brings a risk premium for stocks over bonds!
Social Security Risk
This is a big one! Financial pundits use the fear of social security loss to get your eyeballs and attention.
Social security will not go broke, but there could be a reduction in benefits. Remember, however, that benefits have been reduced in the past by increasing the retirement age and by increasing taxation of social security. And these changes are phased in, so they just affect people who have some time to adjust to them.
If you truly need social security to survive retirement, chances are there will be no cuts to your monthly check. This is especially true if you are close to claiming.
On the other hand, if you have other assets, it is almost certain that the taxation of social security will increase. You paid in more during your working years, and you get less in retirement. This is not a risk because you just need to assume it will be true. If you have other assets, it still pays to wait as long as you can to claim social security and just deal with the reduction in benefits. Plan for it to happen, and be pleasantly surprised if it doesn’t.
Summary—Mitigation of Retirement-Specific Risks
A single risk will often not sink your plan. Instead, it is risk of multiple risks that you need to be wary of.
Once you understand some of the risks to watch out for, you can make a plan.
Remember, you have to start at the beginning: determine your goals!
Next, decide how likely and costly it will be to mitigate retirement-specific risks. And then learn, read, and ask questions.
What will you do?
It is always a good time to retire if you have a plan!