The riskiest day of your life

The primary financial goal for most people is to make sure that their assets last as least as long as they do. The day on which there is the greatest risk of failing to meet that objective is the day you retire. The reasons, as Someday Rich authors Timothy Noonan and Matt Smith explain, are the day you get your gold watch, you have:

  • Exhausted your human capital (ability to generate income from your labors)
  • Assumed "longevity risk" (the need to fund your living expenses for the rest of your life)

Of the many risks we face when developing a financial plan, longevity risk is often the one most overlooked, or at least underestimated. And yet for many individuals, it might be the one that entails the greatest risk. Consider the following:

Today, while a 65-year-old male has a life expectancy of 19 years (to age 84), a 65-year-old couple has 50 percent chance of one surviving to age 92. That means half of all 65-year-old couples will have one spouse alive after 27 years. And they have a 25 percent chance of one reaching 97. Because being alive without the financial resources to support an acceptable living standard is too painful to even contemplate, we must plan for the possibility that we'll live longer than expected. We can reduce the risk of longevity by working longer, delaying taking Social Security benefits and buying longevity insurance (in the form of a payout annuity).

The risk of stocks compounds the longevity problem, because contrary to popular belief, stocks are actually more risky the longer your horizon. While returns are less volatile (the standard deviation of returns is less the longer the horizon), the potential dollar results widen as time increases. Remember, even a small difference in returns (let alone a large one) leads to large differences in compound results as the horizon lengthens. And if you thought that stocks were safe if your horizon was long, just consider the case of the unlucky Japanese investors. In 1990, the Nikkei Index stood at close to 40,000. Twenty-two years later, it's close to 9,000. As Keynes might have said, markets can underperform expectations for a lot longer than you can remain solvent. We can address this risk by not taking more equity risk than we have the ability, willingness or need to take, and diversifying the risks we do take as much as possible, avoiding concentrating assets in single (or small groups of) stocks or even asset classes (such as U.S. stocks). Monte Carlo simulation programs can help you determine the appropriate amount of equity risk to take.

Another major issue we face when we retire is moving from the accumulation phase to the decumulation phase. During the accumulation phase, bear markets can be viewed as positive events as we get the chance to buy low as we add assets. When we hit the decumulation phase, bear markets can lead to selling low. And once you sell in order to spend, you can't recover. For example, from 1973 through 1999, the S&P 500 returned 13.9 percent per year and inflation rose 5.2 percent a year. Thus, the real return for an investor in the S&P 500 Index was 8.7 percent. Knowing that in hindsight one would think you could retire in 1972 and safely withdraw an inflation-adjusted 7 percent of your original principal every year and not worry about running out of assets. However, because the S&P 500 Index declined by approximately 40 percent in the 1973-74 bear market, you would have been broke by the end of 1982! In the decumulation phase the order of returns matters a great deal. Once again, a Monte Carlo simulation program can be of great value in helping you determine an acceptable withdrawal rate.

Another risk that increases when we retire from the workforce is inflation, as we no longer have our wages to rely on -- wages which typically increase with inflation. With the increased risk of inflation, retirees should prefer bonds with returns linked to inflation -- TIPS and I bonds -- and avoid long-term nominal bonds. They should also consider an allocation to commodities as they tend to perform well in periods of rising inflation.

There's another risk that increases as we enter retirement: the risk of increasing health care costs. As we lose the health care benefits provided by most employers, we face the combination of longer life expectancies, the majority of medical expenses occurring during the last years of life, and the fact that medical expenses are rising faster than the overall rate of inflation. This leads many to underestimate the risks. Consider the following. The Employee Benefit Research Institute estimates that a 65-year-old couple without employer provided health care benefits could need $216,000 if they live to 80, $444,000 if they live to 90, and $778,000 if they survive to 100. One way to hedge this risk is to purchase long-term health care insurance.

Even a well-thought-out investment plan can be undermined by the failure to consider the aforementioned risks as some are unrelated to investing. This is why it's important to have an investment plan that is integrated into an overall financial plan.