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A recently shared story from a listener concerned a young worker who bought a luxury vehicle that he quickly realized he couldn’t afford. He sold the original vehicle and bought a smaller vehicle, which was a good idea, but he still retained $18,000 of debt on the original luxury vehicle. He is an independent contractor who now faces increasing business costs. He moved into an office space with lower rent. His business and income subsequently declined. His poor vehicle decision has snowballed and affected his life. This person is worse off financially, and one poor decision has disrupted his life and finances.
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Is it possible for this person to turn his financial situation around?
The short answer is yes. Will it be quick or easy? The short answer is no!
This person never learned good business or financial practices. He will have to make much better decisions to turn his life around. Based on his financial and business history, this will be extremely hard to do.
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Retirement is another season of life where things can go sideways and plans of a lifetime can be quickly disrupted or destroyed. For the vast majority of retirees, there is no earned income to ease the pain of poor financial decisions. Mistakes can compound, leading to stress in other areas. It can happen rather quickly!
There are many things in life over which we have little or no control. Normally, these events have little long-term effect on our lives or finances. The biggest financial problems are self-inflicted. We are our biggest problem! After a lifetime of toiling and saving, don’t let a self-inflicted wound destroy your financial life.
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Here are five questions each person or family should ask when trying to identify retirement financial risks.
What percentage of my/ our income is guaranteed and inflation-indexed?
I put this question first because it is probably the number one Retirement risk for most people. Inflation erodes the buying power of money. Unless dollars are protected from inflation, over time, they will buy less and less. A 3% annual inflation rate will cause prices to double approximately every 24 years. $3000 in monthly income when starting Retirement will have half the purchasing power at the end of 25 years.
Why? Because everything has doubled in price. Due to the effects of inflation, $3000 is now only capable of buying $1500 worth of today’s goods. Reversing the example, $3000 worth of goods 25 years ago now cost $6000. Yet, you still are receiving only $3000. Income indexed for inflation tends to maintain its purchasing power as inflation increases.
The classic example is Social Security payments. Social Security payments are indexed for inflation. This means Social Security benefits adjust annually and reflect inflation’s effect on buying power. For more information on this, you can read or listen to THE BATTLE AGAINST INFLATION: ASSESSING C.O.L.A. PAYMENTS and SOCIAL SECURITY: GUARANTEED RIGHT OR EARNED PRIVILEGE?
It’s important to know and understand how much of a person’s retirement income is inflation-protected. Social Security is indexed for inflation and normally will increase annually. TIPS (Treasury Inflation-Protected Securities) are structured to provide inflation protection to account holders. Most annuities are not indexed for inflation. The more straightforward annuity types may provide a certain percentage increase in annual payments as an inflation-fighting tool. Most annuities do not, and the ones that do will assess a surcharge for that added benefit. More complex annuities add a securities component to the contract to help fight inflation. For more information, read or listen to THE HIDDEN DANGER- INFLATION AND ANNUITIES and FINANCIAL PEACE OF MIND: EXPLORING ANNUITIES FOR SECURITY.
If 80% of monthly income is protected from the effects of inflation, inflation is not as great a concern. If only 10 or 20% of income is indexed for inflation, then it becomes a much bigger concern! It is generally accepted that retirees need to have a certain percentage of assets invested in stocks, as stocks are generally considered one of the best hedges against inflation.
A retiree can minimize the effects of inflation by using one or a combination of these financial products. If implemented strategically and correctly, inflation becomes less of a concern.
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How’s my/ our health? Longevity risk.
Health and longevity concerns comprise two opposing components. A person may have a shorter life, but experience severe or catastrophic medical events. In the second situation, a person lives a healthier and much longer life than normal.
The first component concerns having a very serious and very expensive health crisis occurring earlier in life. Unexpected or unplanned health crises can disrupt retirement plans. Even though this person has a shorter lifespan, financial pressures are much greater. Unplanned medical events and expenses can destroy retirement assets.
A dissenting voice would ask how someone can plan for an unexpected health crisis.
While a person or couple is younger and healthier, plans should be made to either self-insure or purchase long-term care insurance. It often makes sense to purchase long-term care insurance earlier, while a person or couple is still healthy and premiums are more affordable. If a person or a couple opts to self-insure, then an amount between $200,000 and $300,000 (in 2026 dollars) per person should be set aside in a dedicated account for this eventuality. This is the amount generally considered needed to fund approximately two years of long-term care events. For almost every person or couple, one of these two choices should provide adequate funding for long-term care events. A true black Swan event, which is extremely rare, would most likely exhaust funds provided by either of these two options. There is almost no true defense against the bad luck and the financial nightmare surrounding a Black Swan event.
In the scenario above, the financial pressure doesn’t come from an extended lifespan, but from much greater-than-normal expenses in a shorter lifespan.
The second component is opposite the first because it concerns a person or couple living a longer-than-normal lifespan. Most financial planning software assumes a lifespan of around 93 to 95 years. This means that these people should have enough money to live between 93 and 95 years. But what happens if they live longer? Pressure comes from the costs associated with living longer than normal, not extreme health events.
What happens if you have a situation like my mother’s case, where she lived to be almost 101 years old? It’s easy to understand how living 5 to 7 years or more past a projected end of life could cause problems because available money runs out. When money runs out, options become very limited, living conditions may decline, and the family may be forced to supplement a parent’s or family member’s dwindling assets. Fortunately, my mother had adequate assets for her remaining Life.
A person who lives a short life but incurs greater expenses could produce increased financial risks. The same could be said of a person who exceeds a normal lifespan. In most cases, the self-inflicted wounds of these financial risks can be mediated with advanced financial Planning.
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Am I (are we) spending too much?
Although everyone has some control over their health, people have genetic traits that express themselves later in life and cause health problems. People may have little or no control over these genetically induced health problems.
Some people would say humans are genetically disposed to overspend. This is not true, and overspending should be one of the easiest risks to mitigate in Retirement. Unfortunately, this is also not true. Habits formed early in life are very hard to modify.
Many people want to accelerate spending earlier in retirement while they are healthier and more able to do things. Travel, hobbies, and dining out earlier in Retirement mean increased spending. This unplanned spending early in retirement can have a disastrous effect on the long-term health of a retirement plan. Things could get worse if early unplanned spending is coupled with a poor sequence of returns, where portfolio values decline. Overspending and an early bad sequence of returns can double the adverse effects on a retirement plan. In this case, retirees are drawing more money than planned from a declining portfolio. This could cause portfolio depletion early in retirement, causing a person or couple to run out of money. For more information, see: WHAT’S YOUR HORIZON?
A well-thought-out retirement plan should account for increased spending during this early Retirement period, and also make provisions for a poor Sequence of Returns early in retirement.
It’s not all bad news! A favorable sequence of returns early in Retirement means that spending could be increased. This speaks to the importance of periodic monitoring and adjustment of retirement plans and retirement plan spending. Not only is it important to set reasonable spending parameters, but it’s also important that these parameters be periodically monitored. This helps to account for portfolio and spending changes as Retirement progresses.
Like severe health problems that occur early in Retirement, spending problems that occur early in Retirement can create long-term retirement problems.
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Am I (are we) making provisions for Inflation risk?
Proper Asset location and asset allocation provide some of the best protection against inflation.
How does this work? Having all portfolio assets invested in CDs is very safe, but it means the portfolio most likely will not keep up with inflation. Here’s the math: Traditionally, inflation averages approximately 3%. If a CD is returning 3 1/2%, then the return is half a percent above the rate of inflation. However, this number doesn’t account for taxation of the accrued income. For example, a $10,000 CD that returns 3 1/2% will generate $350 of simple income annually. If this investor has an income tax rate of 20%, the after-tax income and principal now equal $10,275. An annual inflation rate of 3% means that at the beginning of year two, this amount will purchase what $9967 would have purchased the previous year. So, even after adding in income, the purchasing power of the principal has declined. These results will always be dependent on the effects of inflation, taxation, and interest rates. In general, though, the purchasing power of CDs declines over time because CDs can’t keep up with inflation and taxation. CDs would be a poor location for the majority of retirement assets. Historically, stocks have been the best form of inflation protection.
It is generally accepted that an asset mix of 50% to 60% Stocks and 40% to 50% bonds or cash-like vehicles provides the best mixture of inflation protection and safety.
Asset allocation concerns how the stock portion of a portfolio is divided among different types of stocks and mutual funds. Dividing assets between different domestic and international stocks and mutual funds provides diversification. It also decreases portfolio volatility while increasing portfolio survivability.
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Am I (are we) still invested too aggressively?
Market risk is always a problem for investors, but it is a greater problem for retirees. Severe market declines can cause a corresponding severe decline in portfolio assets. The problem for retirees is that Time Horizons are shortened. This means there are fewer years left in a retiree’s life to recover from the effects of a severe market decline.
Being 100% invested in stocks is not a bad strategy for a young person. It is also a good strategy if someone has many years left before retirement, and the money is not currently needed. For younger investors, a severe market decline provides an opportunity to purchase stocks at lower prices. Most of these things are not true about retirees. Most retirees are no longer young. Most older workers are retired or semi-retired and need portfolio assets to provide the money necessary for living and luxury items. Retirees are generally not stock purchasers, but stock Sellers.
A severe market decline means that stocks must be sold at lower prices. It also means that stocks are sold from a portfolio that is declining in value. These stock sales have a greater impact on a declining portfolio than on a portfolio that is increasing in value. Pre-retirees and early retirees can mitigate this risk by decreasing stock exposure. For more information on this topic, read or listen to PORTFOLIO DE-RISKING.
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Final Thoughts
Five simple questions. Five complicated answers! Each person’s situation is different and calls for a different answer to each of these five questions.
Work towards securing as much guaranteed income as possible. If it makes sense, delay claiming Social Security benefits until age 70. If an annuity makes sense to guarantee more income, then it is likely a reasonable solution. You may have a pension, or you may want to provide pension-like income through an annuity.
Protect your health as much as possible. If you are not going to self-insure, then it may make sense to purchase long-term care insurance to protect against long-term and financially draining medical problems.
Evaluate anticipated spending before Retirement. Establish a reasonable spending plan and don’t overspend. Annually monitor what you are spending. Overspending will put increased pressure on a portfolio already under pressure.
Make sure your assets are positioned properly to protect against inflation risks. Asset location and allocation matter. Diversification helps to mediate risk.
De-risking a portfolio before retiring or early in retirement protects against market decline. As retirees’ ages increase, there is less time to recover from extreme market losses.
These are simple questions with complicated answers that need to be carefully and thoughtfully considered. Individually, or in combination, these five situations can severely impact portfolio health and longevity.
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