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5 retirement planning blind spots

Christine Benz  |  17 Sep 2019Text size  Decrease  Increase  |  
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Your portfolio balance has gotten larger and larger. You've crunched the numbers, conferred with your spouse and family, and set a tentative date. You think you might be ready to retire.

But before you pull the rip cord and start relying on your portfolio – rather than your salary – for living expenses, it's wise to make sure you're not missing anything on the financial front.

Here are some trouble spots that have the potential to catch retirees off guard.

Market risk

Not surprisingly, individuals have a tendency to retire when the market is up and their portfolios are enlarged. Indeed, in a recent survey conducted by the Employee Benefits Research Institute , two of three US workers said that they were somewhat or very confident in their ability to retire.

Yet periods of enlarged portfolio balances often coincide with heightened market valuations--and heightened levels of risk. Research conducted in 2012 by Rui Yao and Eric Park demonstrated that even though people often retire after periods of strong market returns, that, somewhat counterintuitively, tends to reduce their portfolios' sustainability rather than enhance it.

Today, prospective retirees have to contend with the one-two punch of not-cheap equity valuations and very low yields on bonds.

Does that mean that you should park your whole portfolio in cash, or worse yet, defer retirement until after stock prices have already fallen – and run the risk that you'll be too spooked to retire at all? No. But it does mean that you should earmark enough of your retirement portfolio for safe securities, which you can draw from to tide you through periods of equity- or bond-market weakness.

You can also plan to reduce your portfolio spending in periods of extreme volatility. This article discusses the possibility that new retirees will encounter volatility in the early innings of their retirements, and what they should do if that’s the case.

Inflation

It's tempting to not get too worked up about inflation and its impact on your retirement plan. After all, CPI has been running at a fairly benign level for the better part of a decade. And in any case, how could such innocuous little numbers like 2 per cent or 3 per cent make a big difference in the success or failure of your plan?

One of the key reasons you should care about inflation in the first place is that if you've staked a decent share of your portfolio in fixed-rate investments like cash or bonds – as is only prudent to do leading up to and in retirement – higher prices on goods and services you need to buy will erode the purchasing power of your returns on those investments.

Another way to think about it is if you've staked more of your assets in conservative investments as retirement approaches, that lowers the absolute return you're apt to earn on your portfolio, and inflation could take a big bite out of your earnings.

If you're lucky to earn 5 per cent on your money, you sure as heck wouldn't want to give up 60 per cent of that gain, as you'd effectively do if inflation runs at 3 per cent during your retirement years.

There's also the fact that inflation has been kicking up a little bit recently, and, more importantly, that inflation for older adults has tended to run higher than the general inflation rate. In large that's part because healthcare-related expenses are a bigger share of the average older adult's total household outlays, and those costs have been running about 70 per cent higher than the general inflation rate.

Financial adviser Carolyn McClanahan, a medical practitioner who specialises on the intersection between healthcare and financial planning, has argued that the current rate of healthcare inflation is not sustainable. But for now, at least, they're a force to be reckoned with.

You can defend against inflation in a couple of key ways.

One is to embed direct inflation hedges like inflation-protected bonds in the bond portion of your portfolio; when inflation goes up, you get a little raise on the principal or interest coming from the bonds.

But don’t stop there. At the risk of stating the obvious, those inflation-protected bonds only confer inflation protection upon the portion of the portfolio you've invested in them. Moreover, because the inflation adjustments you receive on those bonds are keyed off of the general inflation rate, not the inflation rate you personally experience, they may not reflect your actual purchasing experience.

If you have a lot of healthcare expenses, for example, that will tend to push your personal inflation rate above the general inflation rate. I think the best way to help address that issue is to simply hold a healthy share of your portfolio in stocks throughout retirement.

While by no means a direct inflation hedge – if inflation goes up by 3 per cent in a given year, your stock portfolio is by no means likely to return the same – over time equities have provided the best long-run shot at out-earning inflation.

Taxes

Your portfolio balance might look comfortingly large. But unfortunately, it's probably not all your money. If you have assets in tax-deferred accounts, you'll owe ordinary income tax on the bulk of your withdrawals.

After taxes, your withdrawals could shrink considerably. The government also has a claim on any appreciation you've enjoyed in your taxable accounts and haven't yet payed taxes on. Those levies can take a bite out of your take-home return.

You'll face other taxes in retirement, too.

There are various considerations you need to make about the minimum payments you draw from any pension products in a given financial year.

As professional actuary Melanie Dunn points out, there can be serious consequences in failing to meet minimum payment requirements.

Healthcare/long-term care expenses

Many people assume that the public health system and Medicare will cover all their medical costs in retirement, but retirees confront an array of healthcare expenses, such as prescription drug costs. Other long-term care expenses, if they arise, will also take a significant chunk out of your portfolio.

There's no way to avoid at least some of these costs, but at a minimum you should factor the above costs into your in-retirement household budget.

How to plan for long-term care expenses is the most vexing question facing most pre-retiree households.

Meanwhile, actual long-term care costs have also been inflating at a higher rate than the general inflation rate, increasing the burden for retirees who expect to self-fund for such expenses.

Unanticipated expenses

Even if you've calibrated your budget to a T and taken a closer look at how it might change in retirement versus when you were working, it's still wise to set aside cash to cover unanticipated expenses.

While your emergency fund in retirement needn't be as large as it was when you were working, holding enough liquid assets to cover those lumpier outlays – whether a new roof or a big dental bill – is a best practice in retirement.

You might even take the next step of forecasting those periodic, large, off-budget outlays and incorporating them into your spending plan. Doing so will help ensure that they don't throw you off of your planned withdrawal rate.

This article has been adapted for an Australian audience, having been first published for US readers on Morningstar.com

is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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