An old don from my school days was fond of quoting that life is just one damn thing after another. There’s a corollary too—life isn’t just one damn thing after another, it’s the same damn thing over and over. We’ll talk about the corollary in future posts when we tackle investing. For now, we’ll focus on the main axiom and managing the lifetime of risks that converge when you stop earning a regular paycheck.
A wide range of risks threatens the success of your lifetime financial plan. Identifying and countering those risks is as important to achieving your goals as controlling your savings and expenses and managing your long-term earning potential and investments. In other words, your lifestyle depends upon the human and financial capital that provides your cash flow minus the impact of risk. The better you understand and manage the risks you face, even if they may not emerge until later in life, the more successful you will be in offsetting any harmful impact.
I’ll focus here on the key financial risks that converge as you near retirement when their impact magnifies, and you are possibly less well positioned to manage them. For the moment, we’ll leave aside discussing property, life and casualty risk for a larger discussion about insurance at another time. Yes, you still need property and casualty insurance in retirement—you still have property and casualty risk. Life risk generally turns into longevity risk as we age, but not always—if you have young children, for instance. And sometimes a life risk solution is used to fund estate/legacy concerns.
When you are busy working, your main future concerns revolve around saving and investing. If you deal with a registered financial advisor who sells securities, that advisor will focus mostly on managing market risk in his or her product recommendations, pairing, say, a balanced portfolio with the firm’s secret sauce for avoiding losses (twenty years ago during the 90’s bull market, the pitch was the firm’s secret sauce for beating the market). They’ll size you up, ask you a half-dozen risk tolerance questions that allow them to prove their recommendations are suitable*, and off you go all fitted out with their latest investment contraption. Or maybe you’re just clicking through the guideline bullet points on your 401(k) plan’s web pages, trying to decide what to do. Both cases may leave you exposed to risks you are unaware of that can become a serious concern later on.
Broadly, there are risks that affect everybody, called systematic risks, and those which are specific to you as an individual or a household.
The major systematic risks are political risks and business risks.
Political risks include inflation risk and public policy risk. Inflation undercuts the value of your savings. Policy risk breaks down further as tax rate risk, Social Security benefits risk (“Old Age and Survivor’s Insurance” is the official name of the benefit program), and Medicare benefits risk. Policy risk is the risk surrounding the ‘fiscal cliff,’ which is driving the current news cycle. It can significantly change both your income (SS) and expenses (taxes, healthcare) in retirement.
Business risks include market risk and issuer credit risk. These are the risks that impact savings and investment accounts that the SEC requires registered reps to account for when selling “suitable” securities to retail customers. Like inflation, business risks can seriously deplete your savings, engendering higher longevity risk (outliving your money).
Specific (Individual) Risks
Specific individual and household risks include behavioral risk and chance.
The main behavioral risk in retirement is spending risk. Out of control spending is a critical behavioral risk anytime in life. In retirement it could leave you a ward of the state.
Individual and household risks of chance include longevity risk, household shock risk, and healthcare expense risk. The effect of chance on your lifetime financial plan cannot be discounted. Longevity risk is as simple as living much longer than you thought you would, and thereby outliving your savings. Longevity risk also increases from things you can’t control like inflation or policy risk, which affect your savings and expenses, and from things you can control like inadequate savings, poor planning, excessive spending, and business risk to investments.
Household shock is the unhappy occurrence of a serious accident, disability, illness, or death. These shocks can derail a plan, cutting income from earnings or SS and pensions, while increasing healthcare expenses. Healthcare expense risk, surprisingly, increases the healthier you are and the longer you live. A serious illness for an otherwise healthy, robust person may come late in a long life when savings are drawn down, be protracted, and require costly long-term care. But not always. That’s why healthcare expense is a risk of chance.
That’s a lot of risk!
Wow, so how do you learn to love retirement? I’d betray my mission if I didn’t answer, by planning well! A well-made lifetime plan at any age starts with the arc of your life and your personal balance sheet. Then it looks at each of these risks to determine the level of your exposure to each risk, the severity of its consequences to your balance sheet, and its probability for impacting your life and finances.
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Exposure varies throughout life, and typically increases during retirement when human capital (earnings) is no longer a large offsetting factor for risk. This is why younger people are often advised to have a higher allocation to riskier investments—not because they are younger or risk somehow magically vanishes over time (it doesn’t!) but because they have a larger amount of human capital to convert into financial capital over their remaining lifetime.
Consequences depend in large part on the strength of your personal balance sheet, which includes your human capital. Once you have a solid sense of your exposure to and the consequences of each risk, then you can evaluate the probabilities of each risk affecting you and put in place appropriate risk management.
Hopefully you can see why this planning necessarily comes before committing your savings to an investment plan. A brokers “risk tolerance” questionnaire doesn’t begin to address these important issues, and the most appropriate investments consistent with your lifetime financial plan.
Early on, your investment plan might be a simple generic allocation during that time that the risks that will ultimately overhang your lifestyle (and your growing resources) are just beginning to emerge. As time goes on, you need to make risk management a more important part of your planning and your investing, adjusting savings, expenses, and investments to effectively manage the threats that can otherwise undermine the most well intended planning.
Next time, we’ll explore the methods for managing these risks and how to incorporate them into your lifetime planning.
— By Michael Lonier , RMA℠
*“Suitability” is a regulatory requirement for brokers. The risk tolerance test was devised as a legally defensible method for meeting that requirement. It merely addresses whether the proposed investment is suitable as an investment for the customer, not necessarily that it best addresses any other factors in the customer’s financial circumstances.