If you’re fortunate to have lived a long while, you’ve probably worked hard and dodged or overcome any number of obstacles in the challenging race that has delivered you to the present. If you’re gazing ahead at retirement, you might hope the obstacles are fewer and far between, the horizon flat and sunny, maybe leading right up to the beach or the edge of a sand trap.
It’s not that easy or simple, of course. Last time I reviewed the kinds of systematic risk that can impact your financial well-being and how to manage them. Systematic risk affects all of us as participants in the global financial system, though maybe not with the same severity or consequences. Inflation, policy risk affecting taxes, Social Security, and Medicare coverage, and market, business, and credit risk affecting your savings and investments are all threats to life on the beach.
There are also risks that only affect individual households, and not necessarily everyone in the neighborhood. Assuming you have sufficient homeowner’s or renter’s insurance, car insurance, and personal liability insurance, in this post I’ll review the individual financial risks you need to assess and manage as part of a successful lifetime financial plan.
Individual risks divide between personal or behavioral risk and risks of chance.
Managing Individual Behavioral Risk
Behavioral risk is the risk of mismanaging your money through bad habits and behaviors that you can overcome. Spending more than you earn and racking up debt during your working career instead of steadily saving a portion of your income will severely impact you lifetime financial plan, your retirement lifestyle, and your ability to manage other risk.
In retirement, when saving money is a rare option for retirees, spending too much is chief among behavioral risks. Spend too much, and you may run out of money long before you run out of life. Leisure time presents many temptations for overspending—shopping, expensive restaurants, lavish travel, and expensive hobbies or part-time businesses that don’t work out.
Conversely, not spending enough is also a behavioral risk—this might seem odd, but those who can’t bear to write the checks needed to support a robust lifestyle may damage their household psychology, relationships with friends and family, their standing in the community, and even bring on expensive health issues that could undermine their retirement income.
Other common behavioral risks are the cycles of panic and greed that follow market trends. Greed strikes when you suddenly realize the market is at an all-time high and decide to jump in with both feet, while your friendly advisor, following the financial advisor’s playbook of “make hay while the sun shines,” whispers encouragement in your ear. Panic hits when the market sinks and you decide to sell. Buying high at peaks and selling low in downturns is not a great way to manage your savings and investments.
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The best tool to help you manage behavioral risk is a good plan. A well-crafted lifetime financial plan can help you stay centered and in balance as you enter the obstacle course of retirement. This series of posts may help you plan, or you can seek the help of a qualified fee-only planner who isn’t pushing the latest investment or insurance product. A good planner should also be a good behavioral coach, challenging you to maintain discipline in both up and down markets and lean times.
As in most things, you need to find a balance, based on your personal balance sheet and a sound analysis of your essential and discretionary expenses, to ensure your savings and investments are well-matched (and well invested) against your essential needs, wants, and nice-to-haves. Part of that balance is developing an understanding of how money fits into your family’s values, somewhere along the bar between spendthrift and miser. Manage your values well, and perhaps your money will follow, right on plan.
Managing Individual Risks of Chance
Risks of chance are risks over which we have little or no control—the accidents of heredity, random events, good luck and bad. No one can predict these events, but we can prepare for them.
Two individual risks of chance are at the core of retirement planning—longevity risk and healthcare expense risk. Assessing and managing the probable impact of these risks on your household is key to a successful lifetime financial plan.
Longevity risk is the risk of outliving your money. The average life expectancy today for men who reach 65 is age 83, and for women, 85. You could live much longer—over 40% of those age 65 will live longer than 83/85. 25% will live past age 90, and 10% will live past age 95. If you are otherwise healthy and age 65, your retirement income plan needs to cover your income needs for another 30 years—and there’s still a 10% chance you will outlive the plan. Even if you have significant health issues, prudence suggests your plan should span 20-30 years.
Of course, your mileage will vary. No one knows how long their life will last. If you’re interested in a science-based multi-factor test, go to www.livingto100.com for one of the best. If nothing else, it will help you better understand the effect of your lifestyle on your life expectancy. But unless you have a serious health condition with a poor prognosis, base your planning on 30 years.
How do you manage longevity risk? By matching your essential and discretionary expenses to a secure income floor from Social Security, pensions, risk-free investments (TIPs) and guaranteed income products (simple immediate annuities). Any remaining savings and investments should be managed in an upside portfolio at a risk level appropriate to your balance sheet. This implies avoiding overspending and managing your savings to provide secure lifelong retirement income.
This is the core of lifetime financial planning, and I will go into more detail in future posts as we dig deeper into this. The earlier you start your lifetime plan, the smoother your path into retirement.
The Elephant in Your Hospital Room
Healthcare expense risk is one of the pivotal economic topics of our time. To manage that risk, your lifetime plan should provide adequate funding for possible increasing costs for healthcare insurance beyond today’s Medicare premiums, as well as a strategy for paying for long-term care.
Medicare does not cover everything. There are out-of-pocket deductibles and coverage limits that auxiliary Medigap policies cover at additional cost. Retirees also face paying more for less Medicare coverage in the future, with the growing coverage gap coming from private insurance plans, further increasing out-of-pocket costs.
The cost of long-term care is enormous—anywhere from $50,000 to $125,000/year in today’s dollars for a stay in a nursing home or assisted care center. Because the cost is high while the possibility you may need it is uncertain, insurance has been the traditional way to manage long-term care expense risk.
As with health insurance, long-term care costs continue to rise, threatening the viability of traditional stand-alone long-term care policies. Several carriers have stopped underwriting coverage. It’s fast becoming the case that only those who can afford to self-insure can afford the cost of LTC insurance. Those with assets between $500,000 to $1,000,000 are most at risk—the LTC costs of the first spouse can wipe out the savings for the survivor.
Ironically, the cost of long-term care for seniors can fall heavily on those who are most healthy entering into retirement. They live longer and, if not beset by serious illness, may linger in a frail state at the end of a long life, creating a sizable bulge in expenses when their resources may have already been challenged by funding a long retirement.
According to Barron’s, even though more than 10% of those reaching 65 will have a stay of more than 5 years in a long-term care facility, 90% of seniors are uninsured. Contrast this with estimates that over 80% of the 125 million homes in the US are insured, while only 400,000 suffer fires each year—a mere third of one percent. And some of you are probably wondering why only 80% are covered.
The issue comes down to the cost. You must pay LTCI premiums year after year. When you stop paying, your coverage ends, and if your health has changed, you may never again qualify for coverage. Paying significant premiums over decades with an 80-90% chance that it will never pay off is too big a gamble for most—even while paying home insurance with it’s more than 99% chance that it will never be used to cover a large loss. Behavioral finance (behavioral risk alert!) suggests this is overconfidence bias—the belief that we’re better than average and will escape these odds, while at the same time plainly recognizing that our house is just a house.
As an alternative to traditional LTC insurance, a number of carriers are offering linked-benefit policies with long-term care benefit riders attached to single-premium universal life insurance or income annuity contracts. These hybrid policies offer permanent coverage, without rising rates or additional payments, with 2x-5x the single premium payment as a payout in lifetime LTC benefits.
Though the LTC coverage may be costlier than with traditional policy, these products do double duty and return significant economic value even if you never step foot in a nursing home. Hence, their appeal to those who reject traditional LTCI and it’s potential lack of payoff.
For a life policy, if the LTC benefit is not used, the policy pays the life benefit to heirs. For an annuity contract, which typically does not require health qualification, the annuity can be accelerated when LTC reimbursement is needed and the LTC rider provides coverage beyond the value of the annuity. Meanwhile, it pays a monthly check for one or two lifetimes, depending on the contract.
The catch? You need at least $25,000 or $50,000 of cash that’s not working very hard for the single premium payment—perhaps the part of your savings earmarked for LTC self-insurance. Spent on a hybrid LTC product and not some other future exigency, you have the comfort of knowing that at least some of your risk of LTC expense is covered.
These products are complex and vary considerably from insurer to insurer—you should consult an impartial planner to help sort them out and not rely on the agent’s sales pitch.
Bad Luck and Trouble
At the end of the day, the best plan, is, well, just a plan. Life is what happens while we’re busy making our lifetime plan. Household shock risk is the risk that serious adverse events will disrupt our plans and well-being. These events include the death of a spouse and loss of their income or benefits to the family, divorce, unemployment, long-term disability, the onset of serious health issues, and large casualty losses that can never be fully reimbursed.
These life shocks occur more often than most of us think. The University of Michigan’s Health and Retirement Study found that of the 20% of men and 25% of women age 55-64 who had work limiting health conditions, only about 5% were still working.
Back to that obstacle course I mentioned at the top: How do we make a plan that is resilient to life shocks? We should start by recognizing that even the best plan will need to change to reflect the inevitable changes in our lives, that sometimes we need to unwind things that are hard to unwind, and that sometimes we just have reach deep and start over.
— By Michael Lonier , RMA℠