(MoneyWatch) It's understandable if your head starts to spin when you consider the risks in planning your retirement. That's because you've got to take steps to protect against most, if not all, of these risks, including:
- Living too long and (known as longevity risk)
- Inflation eroding your purchasing power
- Poor investment returns bunching up early in retirement (referred to as "sequence of returns" risk)
- Acting on
- Incurring expensive medical conditions and/or
- Becoming less able to manage your finances when you get older
While a natural reaction to these threats might be to become paralyzed, do nothing and hope you won't encounter them, I'd counsel against that -- that would be like putting your head in the sand and hoping the risks won't find you. Hope is neither a good nor effective strategy! You'll be much better prepared for your retirement if you take steps to address these risks.
Another natural reaction would be to seek some certainty in this uncertain world. A lot of people just want to be told what to do by people they trust. The trouble is, that trust is often misplaced.
Many gurus, fraudsters, unethical or incompetent advisors, and some financial institutions make a lot of money by "guaranteeing" certainty if you follow their advice or buy their products. This helps explain a number of familiar financial failures, such as the reason that Bernard Madoff's Ponzi scheme went undetected for many years, the popularity of expensive hedge funds that don't deliver on their promises, the prevalence of active fund managers who underperform common indices, and the success of brokers who put their interests ahead of yours when recommending investment or insurance products.
The desire for certainty also helps explain why we pay so much attention to forecasts about the stock market, interest rates, inflation, and the economy in general. Investing and retirement planning would be so much easier if you just knew how the stock market would perform or how long you'll live. But fellow CBS MoneyWatch bloggersand have repeatedly written about the inaccuracies of these forecasts from "experts" who appear to be very smart, with reams of computer data to support their claims.
If you truly understand the critical issues regarding investing and retirement planning and you're honest with yourself, you'll realize that you can't guarantee certainty with all risks. Here's just one example: You might find an investment that's reasonably guaranteed to preserve capital, but that's also vulnerable to inflation risk, longevity risk and cognitive risk.
So if certainty is impossible, how can you proceed without driving yourself crazy? The best way is to adopt the following two-step strategy:
- Step 1: Plan to support the life you want, using your best estimate of the future regarding the economy, capital markets, your life expectancy and so on.
- Step 2: Take reasonable steps to be prepared in the event that your forecasts are wrong.
When you ignore one or both of these steps, the outcomes can range from disappointing to devastating. Most often, people overlook the "prepare to be wrong" step, and then have to drastically change their lives when the stock market or the economy throws them a knuckleball. You only need to think back to the recent stock market crash and high unemployment for examples of this scenario. But even this step should be familiar to most readers, because it goes by such common names as "have a plan B" or "save for a rainy day."
Another aspect of the "prepare to be wrong" step is to periodically revisit and revise your estimates of the future, based upon events in both the economy and your life that have taken place since your last forecast.
On the other hand, some people might dwell too much on things that can go wrong and end up living in a cave, figuratively speaking, not enjoying life to the extent that they might otherwise if they weren't so scared about the future.
Many people already use this two-step strategy in certain financial aspects of their lives. For example, most people want and expect to live a long time, but they also buy life insurance to provide for their family in the event that they're wrong -- that they die prematurely. Similarly, most people plan to live in their house indefinitely and don't expect that it will burn down tomorrow, but they also buy homeowners' insurance in the event that their forecast is wrong and the house does burn down.
Stay tuned for future posts that apply this two-part strategy to various aspects of retirement planning and protecting against the risks listed at the beginning of this post. You'll see that the only realistic certainty is that you can have a practical strategy for living with life's uncertainties.