The hidden risks that can derail a retirement plan
There are all kinds of risks that can send your retirement plan down the slippery slope. The stock market could crash, or the federal government could create an unreasonable tax hike. Luckily, these risks are visible and relatively unlikely. In the financial services industry, we try to look beyond the visible risks. Your transition to retirement should be as smooth as possible, and I want to bring to light some of the risks that are more invisible. I call these the hidden risks.
What are these hidden risks?
Thinking about your retirement plan requires taking a long look at your long term investments. As a finance professional, there are four key hidden risks that always stand out to me.
Personality risk is usually the hardest one to see, because it is your own personality that causes the risk. This can come in many forms. It could simply be a person who takes on more risk than he or she needs. On the other side of the spectrum, it could be a person who is far too conservative and thus cannot achieve their goals because they simply don’t achieve high enough returns or their money deteriorates because of inflation.
Personality risk ultimately comes down to the person. This is the risk that people will let their emotions drive their investment decisions by increasing their risk or investing heavier when markets are very strong but selling when markets are weak (see: the common buy high sell low investor mistake. It’s supposed to be the other way around!). Personality risk can be especially disruptive when thinking about when to retire. It can affect your ability to set and stick to realistic financial goals, and harm your long-term investment income once you’ve retired.
The good thing about personality risk is that it can be mitigated. This is where having an investment partner – be it your spouse, friends or financial consultant – can be especially powerful. If you identify as someone who takes risks in their day-to-day life, consider how your personality may affect your investment strategy.
Define longevity – in this context, it is having the good fortune to live a long and fruitful life. This is of course a great thing, but can pose a risk to your financial security in the long run.
Longevity risk is a retirement risk that becomes more and more realistic for more investors every year. This refers to the risk of outliving your retirement savings. As medical advances improve, people are starting live much longer than anticipated. In developed countries, life expectancy has risen from 65 years old to 85 years old in the last 50 years. People are living longer than ever and that trend is predicted to continue rising. This article from Time magazine suggests that upper-middle class individuals aged 65 have a 43% chance of living to 95. Those are good odds of living a long life.
This makes planning for retirement a bit more complex. We now know that people will likely be living longer, and we must adjust our retirement plan options accordingly.
When beginning to ask yourself the “When should I retire?” question it is a good idea to consider living much longer than the average. You never know what your health will look like, or what kind of medical advances may pop up in the next 20 years. Longevity risk in terms of your retirement is a real risk, but it can be mitigated against! The following are some basic personal steps I can recommend for understanding your longevity risk:
- Understand your health. This includes speaking with your doctor regularly and following their direction. Keeping tabs on your own health is important at any age of course. In planning your finances for the long run it is important to have an idea of how long to plan for. Understanding your health is your due diligence to imagining your longevity.
- Maintain your health. Staying fit and living an active lifestyle will keep your health in check. This not only keeps you feeling good but will also allow you to limit your expensive medical care in the future. A healthy body equals a healthy chequebook in retirement!
- Invest appropriately. Ensure that you have your expenses properly covered. Check back to my last article about monitoring your spending in retirement and tracking your net worth. Knowing these metrics will allow you to invest enough to suit your risk profile and lifestyle.
Longevity risk is one of the emerging risks that markets around the world are just beginning to clue into. Check back next week for a more detailed article that will outline the financial measures you can take to mitigate against longevity risk.
These are risks that arise from legal proceedings surrounding your retirement period.
A divorce is a common legal risk that can literally cut your retirement in half. The lack of a will can also cause a legal risk to your retirement. A will is the legal instrument that permits a person, the testator, to make decisions on how his/her estate will be managed and distributed after his/her death. Without this, the intention can be left unclear, opening the window for others to lay claim to the estate.
In a blended family the spouse and the children of the deceased individual could be at odds to their entitlement. Proceeds that may have been assumed earmarked for retirement may now be at risk. There may also be the scenario when an individual is counting on an inheritance to fund part of his retirement. Without a will in place to show these intentions family members may lay claim to the inheritance reducing ones expected amount. Just the legal costs alone to settle any disputes over the claim to an estate could substantially reduce the amount of money left to an individual.
This video does a good job to explain some of the broad legal risks associated with retirement and an unfortunate divorce.
Staying on top of your legal work which includes ensuring that your will is squared away, your family finances are settled and you accounts are balanced will help you and your family avoid painful and costly expenses when you move towards retirement.
Emergency risk is dangerous because the type of the risk is so unknown. It is hard to prepare for emergencies, because you never truly know when one will strike. However, there are some pitfalls that can be easily avoided and ensure that your family is able to respond quickly to financial emergency situations.
It is suggested that an individual should have an emergency fund equal to at least 3 month’s salary put aside. This amount was based under the assumption that if an individual was unable to work, their benefits plan would kick-in after 90 days. What about those without benefits or those that have benefits but it is still not enough to cover their bills? How about those that are laid off and their EI benefits will not leave them with enough to get by? A rule of thumb is really a starting point, but one should look at their unique situation to identify the true risk to properly mitigate the situation. Strategies of having access to liquid assets or insuring an appropriate amount of coverage are just a few ways to mitigate this risk, but understanding the risk first of all, is the first step to protecting yourself and your family.
Some may consider their RRSP’s as an emergency fund option. Your RRSP’s should never be part of your emergency risk plan, but they are of course an option if you so need to access them. By accessing the money out of your RRSP’s you are directly affecting your retirement plans and the amount of money you will have at retirement. The money that is pulled out of your RRSP is taxed immediately requiring even more money out of your RRSP to supplement your income. Example: $10k would be needed to provide $8k income at withdrawal (20% withholding tax). This withdrawal is added to your income for the year, which may require even more tax owed, depending on your overall income for the year. RRSP type investments are usually invested for the long term, leaving an ill-timed withdrawal that could even compound the loss to the account. Having an emergency savings in a Savings account, TFSA, or a Non-registered account with conservative investments can limit this tax risk and the impact on your retirement. A conversation with a financial professional can help identify, plan, and mitigate this risks before they happen.
The four major risks that can derail your retirement plan are the Personality Risks, Longevity Risk, Legal Risk and Emergency Risk. These are all risks that can be brushed away, thinking that it will never happen to you when many of these risks can be planned for and dealt with in advance. Maybe that can be attributed to individuals underlying personality risks, but it is always in your best interest to consider every possible risk facing your health, your family and your finances.
Thanks for reading!
Thanks for reading!
If anything on this blog interests you further, please do not hesitate to reach out to me via email at [email protected] I’d love to talk about my financial services and advice in Vancouver, British Columbia’s lower mainland, and Canada in general.
- Brad Blair, CFP, CIM, FCSI, CHS.