Did you know that of those who die on Mount Everest, 80% died not on the way up, but on the way down? They had so diligently planned and trained for how to climb the summit that they didn’t plan nearly as much for the dangers of getting down. Reasons for failure include lack of fitness and strength, lack of oxygen and issues with weather and traffic on the mountain.
I’m using this metaphor to describe how people plan for retirement. They spend all their working years planning and accumulating, so they can have the most amount of money and get to the top, but when they are finally in retirement, most people have no plan for how to distribute assets to provide a dependable income stream.
I’d correlate the lack of fitness, strength, oxygen, weather and traffic on the mountain to financial factors such as market volatility, how long we may live in retirement and taxation. All these issues need to be identified and planned for, or you’ll have major issues coming down the mountain — providing a dependable retirement income.
Stock market volatility, your longevity and taxes are the three risks you need to prepare for as you near retirement. Let’s consider each of them:
Preparing for stock market volatility
Since 1900, the stock market has done really well over the long haul. However, if you break it up into five-to-10-year segments, there has actually been some pretty serious volatility (not to mention the awful, wild swings we’ve seen lately). To understand how to prepare for stock market volatility as you retire, it may help by answering two key questions:
What does volatility mean to my retirement?
For the sake of argument, let’s imagine we’re sitting in a bull market and you’re retiring in five years. History has shown, however, that a bear market — a sustained loss to the stock market — will come. That’s why when we retire can be as important, or more important, than how much we actually save for retirement.
Focusing on strategies that avoid those bear market times is the first step in dealing with volatility; smooth out the volatility so you don’t experience those large losses.
What happens if I invest in the stock market and it tanks?
Let’s say you were to invest $100,000 into the stock market. The first year you lost 30%. How much do you think you need to earn the following year to get back to your original $100,000 or break even? Isn’t it the same 30%?
Nope. It’s 42%. The reason is because you’re earning income on less money.
In this example, you only had $70,000 in that second year to invest rather than $100,000, so you need to earn 42% rather than 30% to get back to your original amount.
The moral: try to invest more than you think you need to, and diversify well among stocks and bonds, so you’ll be better prepared for inevitable stock market drops.
Preparing for longevity
The risk of living a long time is not necessarily a bad thing, but you need to be prepared for it.
As you think about longevity as a risk, have you considered the probability that you’ll need long-term care, and the expenses of this care? Most people don’t, but it’s a significant issue and the risk is only magnified with our increased chances of living longer.
The average annual costs today of nursing-home care is $83,950. In 10 years, it will be $136,746 a year — assuming only 3% inflation.
Once you hit 65, though, the odds of needing long-term care at some point are about 70%.
The reality is that long-term care costs have tended to increase at a higher rate than the general cost of living. That’s why longevity, with the inclusion of inflation and long-term care, is a huge risk to consider during retirement. You’ll want to either have long-term care insurance or enough in savings to cover the possibility of long-term care expenses.
With the challenge of longevity in mind, the idea then, is to not only accumulate the maximum amount of wealth, but also to distribute those resources in the most tax-efficient manner so you can make it to the “bottom of the mountain” safely. A consideration of inflation also factors in to how you distribute your resources. The average has been 2% to 3% a year — or higher. Longtime financial strategist Doug Andrew points out why you should consider inflation when planning for your retirement.
Preparing for taxes
This leads to the third biggest risk most often overlooked by those heading into retirement: taxes.
It helps to think of your retirement money in the three ways (or buckets) it might, or might not, be taxed:
Taxable money: This includes liquid accounts that are taxed on an annual basis as a result of earned dividends or recognized capital gains. They could be savings accounts, interest-earning checking accounts, stocks, bonds (other than municipal bonds) and mutual funds (other than tax-free municipal bonds).
Tax-deferred money (taxes postponed): This is where most of us accumulate wealth, outside our homes. Tax-deferred money is a great option because postponing taxes allows money to grow faster through uninterrupted compound interest. When it comes to investing with tax-deferred money — such as a traditional individual retirement account or a 401(k) — the question really becomes: Do you think tax rates will be higher, the same, or lower in the future? History tells us that taxes will go up.
Tax-free money: This could be municipal bonds or a municipal bond fund, It can also be in the form of a Roth IRA, where you earn a dollar, pay taxes on it, contribute and grow that money and then access it tax-free in retirement. But there is a catch: If your income exceeds $135,000 in 2018 or $135,000 in 2019 (filing single) or you’re married and file jointly and your income exceeds $199,000 in 2018 or $203,000 in 2019, you can’t contribute to a Roth IRA. And even if you can contribute to a Roth IRA, there are annual limits. In 2019, the maximum you can put into a Roth IRA will be $6,000 if you are under 50 and $7,000 if you are 50 or older.
You’ll want to ensure your portfolio is diversified, from a tax standpoint, across all three of those buckets — taxable, tax-deferred and tax-free — with an emphasis on having as much as possible in that last one, the tax-free bucket.