With so much at stake when planning a retirement income stream,
it pays to take a step back and see whether your plan takes into
account the major obstacles to retirement income adequacy. When you
take this big-picture view, consider the five major challenges most
retirees face: the potential for outliving one's assets; the threat
of rising living costs; the impact of increasing health care costs;
uncertainty about the future level of Social Security benefits; and
the damage to long-term financial security that can be caused by
excessive withdrawals in the early years of retirement.
Understanding each of these challenges can lead to more
confident preparation.
Examining the Issues
Longevity. While most people look forward to
living a long life, they also want to make sure their longevity is
supported by a comfortable financial cushion. As the average life
span has steadily lengthened due to advances in medicine and
sanitation, the chance of prematurely depleting one's retirement
assets has become a matter of great concern.
Consider a few numbers: According to the latest government data,
average life expectancy at birth in the United States is 78.7
years, compared to 47.3 years in 1900. But most people don't live
an average number of years. In reality, there's a 50% chance that
at least one spouse of a healthy couple aged 65 will reach age 89
(see table).1
Chance of Living to a Specific
Age |
|
50% |
25% |
Male aged 65 |
Age 83 |
Age 88 |
Female aged 65 |
Age 86 |
Age 91 |
50% chance at least one of a 65-year-old couple
will reach age 89.
Source: Social Security Administration, Period Life Table. |
Inflation. The tendency of prices to increase
varies over time, as well as from region to region and according to
personal lifestyle. Through many ups and downs, U.S. consumer
inflation averaged about 3% since 1926. If inflation were to
continue increasing at a 3% annual rate, a dollar would be worth 54
cents in just 20 years. Conversely, the price of an automobile that
costs $23,000 today would rise to more than $41,000 within two
decades.
For retirees who no longer fund their living expenses with
wages, inflation affects retirement planning in two ways: It
increases the future costs of goods and services, and it
potentially erodes the value of assets set aside to meet those
costs -- if those assets earn less than the rate of inflation.
Health care. The cost of medical care has
emerged as a more important element of retirement planning in
recent years. That's primarily due to three reasons: health care
expenses have increased at a faster pace than the overall inflation
rate; many employers have reduced or eliminated medical coverage
for retired employees; and life expectancy has lengthened. In
addition, the nation's aging population has placed a heavier burden
on Medicare, the federal medical insurance program for those aged
65 and older, in turn forcing Medicare recipients to contribute
more toward their benefits and to purchase supplemental insurance
policies.
The Employee Benefit Research Institute has estimated that if
recent trends continue, a typical retiree who is age 65 now and
lives to age 90 will need to allocate about $180,000 of his or her
nest egg just for medical costs, including premiums for Medicare
and "Medigap" insurance to supplement Medicare. Because of the
higher cost trends affecting private health insurance, the same
retiree relying on insurance coverage from a former employer may
need to allot nearly $300,000 to pay health insurance and Medicare
premiums, as well as out-of-pocket medical bills.
Social Security. The demographic forces that
have led to an increasingly older population are expected to
continue, putting more pressure on the financial resources of the
Social Security system -- the government safety net that currently
provides more than half of the income for six out of 10 Americans
aged 65 or older.
In fact, the number of workers supporting each Social Security
beneficiary through payroll taxes is projected to decline from 2.8
in 2018 to 2.1 in 2036. At that ratio, there would not be enough
workers to pay scheduled benefits at current payroll tax rates. If
no action is taken to fix Social Security's financial problems, the
system's trust funds may be exhausted by 2034.2 These
trends have raised uncertainty about how Social Security can be
financed in future years and whether benefit levels and eligibility
requirements may have to be changed as the population continues to
age.
Excess withdrawals.3 Retirees must
take into consideration all of the risks mentioned above when
deciding how much money may be safely withdrawn each year from
their retirement nest egg. But retirees also must consider the
fluctuating returns that their personal savings and investments are
likely to produce over time, as well as the overall health of the
financial markets and the economy during their withdrawal
period.
The stock market's collapse in 2008 after a short bull market
illustrates the dangers of withdrawing too much too soon.
Withdrawing 7% or even more per year from a retirement portfolio
during the bull market years might have seemed a reasonable rate.
But the ensuing bear market in stocks raised the possibility that
the value of a retiree's portfolio might be reduced as a result of
stock market losses, increasing the chance that the retiree would
outlive his assets. According to one analysis, the average maximum
sustainable withdrawal rate over any 30-year period for a balanced
portfolio of stocks and bonds was 6.3% after adjusting for
inflation. One strategy that may potentially avoid premature
exhaustion of assets is to adopt a relatively conservative
withdrawal rate of 4% to 5% a year. The same study showed that a
withdrawal rate of 4% was sustainable in 95% of the periods
studied.4
Addressing the Risks
While the risks discussed above are common to most people, their
impact on retirement income varies from person to person. Before
you can develop a realistic plan aimed at providing a sustainable
stream of income for your retirement, you will have to relate each
risk to your situation. For example, if you are in good health and
intend to retire in your mid-60s, you may want to plan for a
retirement lasting 30 years or longer. And when you estimate the
effects of inflation, you may decide that after you retire, you
should continue to invest a portion of your assets in investments
with the potential to outpace inflation.
Developing a realistic plan to address the financial risks you
face in retirement may seem beyond you. But you don't have to go it
alone. An experienced financial professional can provide useful
information, as well as valuable perspective on the options for
successfully managing what may stand in the way of your long-term
financial security.