Imagine how financial planning would be different if the sole focus was on accumulation of wealth while risks were ignored. There would clearly be no need for insurance of any kind. Disability insurance, umbrella insurance, and life insurance, as examples, would just be unnecessary expenses. Individuals would borrow as much as possible to leverage their highly aggressive and concentrated investment portfolios.
Thankfully, most people tend to wisely protect themselves from unwelcome outcomes by buying insurance, maintaining an emergency cash reserve, and diversifying their investments, as examples. However, academic evidence demonstrates that most people tend to be under-protected from some of the key risks of retirement.
For a 62 year-old entering retirement, the financial risks are very different from a 42 year-old supporting a family. Two of the most important financial risks likely faced by the 42 year-old are death and disability. As a result, insurance is commonly purchased to cover those risks. Those same risks, however, are typically not financial risks for a 62 year-old entering retirement. The retiree likely has no need for life insurance or disability insurance. Instead, the risks have shifted and the following become three of the most important risks for the 62 year-old:
1) Inflation Risk. During the accumulation phase of life, most people have income or salary which is adjusted annually for inflation. They also tend to have more invested in stocks, which act as an inflation hedge. Finally, many individuals in the accumulation phase tend to have a fixed-rate mortgage which offers an inflation hedge as the debt can be paid off with cheaper dollars in an inflationary environment. Alternatively, retirees tend not to have any of this inflation protection and so the threat of rising inflation and more expensive goods or services poses a serious risk.
2) Longevity Risk. This is simply the risk that you outlive your retirement resources and is perhaps the greatest financial risk for many retirees.
3) Sequence of Returns Risk. Individuals who retired in 1999 or 2007 are likely well aware of this risk. Specifically, weak equity markets early in retirement pose far greater problems for retirees than weak equity environments later in retirement.
Addressing the Risks of Retirement
Most retirees tend to be aware of these retirement risks but may not do anything to seriously protect against them. What if you were to employ a single strategy to mitigate these risks – what would it look like? The best answer would likely be to purchase a single premium inflation-adjusted annuity from a financially strong provider. The inflation-adjustments mitigate the risk of higher inflation. The stable annuity payments reduce the risk of market volatility or getting a bad sequence of returns. Finally, an annuity that pays benefits for a lifetime clearly mitigates the longevity risk. In an ideal environment, you would add a strong survivorship feature to this annuity so that the surviving spouse would be provided for, as well.
If you are now under the false pretense that this is a sales pitch for annuities, read on.
Social Security Timing Decision
When evaluating Social Security payouts or pension payouts, many people tend to think in terms of the “crossover point” or “breakeven age”. A simple calculation can be done to determine how long a single person needs to live to profit from claiming Social Security benefits, for example, at age 68 rather than 62. The math for a married couple becomes a little more cumbersome but the same breakeven ages can be determined.
So a retired woman might run the calculation and determine that she has to live to 82 years old to benefit from delaying Social Security benefits from 62 to 66. Or the same woman might estimate a fixed life expectancy and then use this life expectancy assumption to determine the optimal Social Security claiming age. There is nothing wrong with these calculations as they do provide useful information in a situation where this woman clearly has knowledge about health or family history that the Social Security Administration is ignoring. However, thinking about the Social Security or a pension timing decision in this binary win or loss way is like living in that world where risks are ignored.
Thinking Differently About Social Security
This brings us back to the idea of hedging the key risks of retirement. Consider for a moment what Social Security really is. Although some might contest this point, Social Security is a pre-paid inflation-adjusted annuity from the most financially secure insurance company on the planet.
If people were to view Social Security in this context and also consider the most significant risks faced in retirement, then they may quickly realize there is a better approach for the Social Security timing decision. Specifically, retirees might stop thinking about claiming as early as possible to make sure they get some of what they paid into the pool. They may no longer defer to the personalized online calculator where the optimal claiming age is provided based on an average life expectancy. Or they may ignore the personal finance article in the paper which suggests that the average married couple is best served by claiming benefits at ages X and Y.
Instead, retirees who face the risks of inflation, longevity, or a difficult sequence of returns might consider maximizing the inflation-adjusted annuity called Social Security. Yes, this entails waiting to claim benefits until age 70 which may mean you have to spend from retirement savings in the meantime. Yes, this creates a risk that if you don’t live until age 70, you paid into a program which gave you nothing in return (ignoring the spousal benefits). But a married couple who collectively does not live beyond age 70 is unlikely to see their financial quality of life suffer, even if they never receive a penny of Social Security benefits. However, what of the couple who lives to age 95? Receiving a guaranteed annual annuity payment of $50,000 in today’s dollars rather than $28,409 for having waited from age 62 until age 70 goes a long way to ensuring a consistent quality of life.
This is certainly not to say that everyone should defer claiming Social Security benefits until age 70. That is not the conclusion that should be drawn (although in most situations, having one spouse defer benefits to age 70 is usually the suggested solution). There are many personalized strategies for separately claiming husband and wife benefits that may be more appropriate and beneficial for specific situations. In fact, there are plenty of situations where claiming benefits early is most appropriate. Importantly, the key point here is that retirees should not necessarily look at maximizing Social Security benefits, which is the intent of most financial calculators. Instead, retirees should consider the objective of minimizing the risk of bad outcomes. This means evaluating the personalized risks of retirement and determining how Social Security or any pension benefit can be utilized to help minimize the risk of unwelcome results.