How Withdrawal Rate Risk, Long-Term Care Risk, and Inflation Risk Can Put Your Retirement Security in Jeopardy
We are all living in – and retiring in – a risk-rich environment. Not only do you need to worry about tax rate increases and longevity risk, both of which I’ve written about previously, but there are other very real dangers to your financial security, too. In this article, I’ll review three of them: withdrawal rate risk, long-term care risk, and inflation risk.
As you read, take notes on questions you may have, and please feel free to reach out to me to schedule a discussion if you’d like to learn more about how I can help you prepare for a financially secure retirement.
Withdrawal Rate Risk
One sub-risk that gets magnified by longevity risk is withdrawal rate risk. This is the risk of running out of money prior to death as a result of taking unsustainably large annual withdrawals from your retirement accounts.
Prior to the early nineties, there was very little science around sustainable withdrawal rates. The prevailing notion held that sustainable withdrawal rates were roughly equal to the average rate of return that could be expected in the stock market over time. For example, if the stock market’s historical return was 7 percent, it would follow that you could take 7 percent distributions over a thirty-year retirement without ever depleting your assets.
To understand whether this approach was viable, let’s apply that 7 percent withdrawal rate to actual stock market returns from 2000 to 2010. During this time, a 7 percent withdrawal rate ($70,000 per year) would have bankrupted your $1 million portfolio 11 years into a 30-year retirement!
Well, that was antiquated, outdated pre-1990s thinking, you must be saying to yourself. Surely Americans in the new millennium have embraced a more enlightened, math-based approach to withdrawal rates. Think again. Consider the study that MetLife did as recently as 2008. They administered a Retirement Income IQ Test to Americans over age fifty and asked a series of questions that included the following:
“What percentage of your retirement savings can you withdraw each year while still preserving your principal?”
Ready for this? Hang on to your hat! An astounding 43 percent of the respondents said 10 percent! Consider the impact of a 10 percent withdrawal rate on the previous scenario.
Based on a 10 percent withdrawal rate ($100,000 per year), you’d run out of money after only 8 years! Without any assets to complement your Social Security, you’d be required to scale back your lifestyle dramatically, move in with the kids, and adopt the scorched-earth rice-and-beans diet advocated by Dave Ramsey. What do you think, could you stomach a steady diet of rice and beans for the next twenty-two years? Probably not quite how you envisioned your golden years.
Have you noticed a trend? Reckless, willy-nilly distributions from your retirement plan can deplete your assets far in advance of your life expectancy. Zeroing in on mathematically acceptable withdrawal rates can help mitigate this risk. (I’ll share more about this in a future article.)
Long-Term Care Risk
While outliving one’s resources in retirement is frequently listed as retirees’ chief preoccupation, not far behind is the concern over a dramatic and unforeseen spending shock.
Retirees worry about spending large, unexpected sums of money on out-of-pocket medical costs, housing repairs, family expenses, and marital changes. But the spending shock they’re often least prepared for is the one that can be far and away the most financially devastating: long-term care.
Of all the spending shocks that are most likely to send your retirement portfolio spiraling into the abyss, a long-term care event is right at the top of the list. While most shock expenses in retirement can be disruptive, they don’t typically clean out the retirement till. Long-term care expenses, however, can force you to burn through a lifetime of savings in just a few short years. This is a spending shock that all too often sends retirement plans into cardiac arrest.
To illustrate the devastating implications of a long-term care event, consider the following conversation I frequently have with my clients:
Me: Mr. Jones, you know I love you, right?
Mr. Jones: Yes, Brian, I know you love me.
Me: I do love you, but you’re better off dying than needing long-term care.
Mr. Jones: [Looking a bit disconcerted.] Uh, why’s that?
Me: Well, at least if you died, your wife would be the beneficiary on all your retirement accounts. And while we would miss you terribly, life for her from a financial perspective would continue along relatively unchanged.
Mr. Jones shifts uncomfortably in his seat, then nods for me to continue.
Me: If you didn’t die, however— let’s say you almost died—and ended up needing long-term care, well, that’s a different story altogether. Almost all the money set aside for her retirement now gets earmarked for the long-term care facility.
She gets to keep one house, one car, a minimum monthly maintenance needs allowance (MMMNA) of about $2,500 per month, and about $128,000 in cash. So, what was shaping up to be a perfectly rosy retirement for your wife turns into basic, bare-bones, subsistence-type living. And, of course, the same would be true for your wife if she needed long-term care. Then almost all of the retirement savings you were planning on living on get earmarked for the long-term care facility as well.
Sadly, this is a painful scenario that plays out for all too many Americans. Their retirement balances all but dry up due to a devastating and costly long-term care event. And who usually takes the brunt of that long-term care event? It’s the community spouse, whose would-be retirement savings are now earmarked for the long-term care facility where their spouse will be living out their remaining years.
So, how does longevity risk compound long-term care risk? It’s quite simple. The longer you live, the more likely you are to experience a long-term care event. For example, only 1.1 percent of Americans aged 65 to 74 are in a nursing home. In other words, the risk of a long-term care event in your first ten years of retirement is statistically negligible.
But after 10 more years, it’s a different story. Once you hit age 85, that number skyrockets all the way up to 15 percent. In short, 15 percent of Americans aged 85 and older can no longer perform 2 of 6 activities of daily living. Between you and your spouse, there’s a 28 percent chance that at least one of you will need long-term care by age 85. That’s a 28 percent likelihood that you will be forced into spend- down and burn through whatever retirement savings you have left.
Now, if you’re both planning on dying at age 85, maybe these long-term care statistics don’t seem so menacing. But what if one of you lives longer than that? Statistically speaking, there’s a 25 percent chance a 65-year-old male lives to 93 and a 25 percent chance a 65-year-old female lives to 96.
And for a 65-year-old couple, there’s a 25 percent chance the surviving spouse lives to age 98. What do you think? Could you survive an extra 10 to 15 years in retirement after burning through your savings to pay for your spouse’s long-term care? Hardly what you were hoping for! In short, the longer you live, the more likely long-term care will derail your retirement plan. (Thanks, longevity risk!)
Inflation Risk
Why is money valuable? Because it’s scarce! But when you print more of it, it becomes less scarce and therefore less valuable. That’s what we call inflation, and it’s a risk that will play an increasingly prominent role in your retirement as our country spirals deeper and deeper into the financial abyss. One of the ways our government hopes to stave off bankruptcy is by printing more money. This is euphemistically referred to as monetization. And as benign as that term sounds, it could exert a massive eroding effect on your purchasing power over the course of your retirement.
To better understand the dangers of inflation, let’s review a mathematical principle with which you may already be familiar: the Rule of 72. Here’s how it works: divide 72 by your rate of growth, and that tells you how many years it takes to double the value of an asset. For example, if your retirement accounts are growing at 8 percent per year, you could expect them to double in value after 9 years.
When used in reverse, however, this rule can give you a window into the eroding impact of inflation on your retirement savings. Let’s use the example of an inflation rate in retirement of only 3 percent. When you divide 72 by 3, you get 24. This means that at 3 percent annual inflation, your purchasing power would be cut in half over a span of only 24 years. What’s worse, should the federal government accelerate the pace at which they’re printing greenbacks and inflation rise to 6 percent or worse (think 1970s), then your purchasing power would be cut in half in 12 years or sooner.
How does all this tie into longevity risk? By now, the connection should be clear. The longer you live, the more inflation erodes your spending power. But here’s the rub: in order to stay ahead of inflation, you have to grow your money. In order to grow your money, you have to take some risk in your retirement portfolio. And the amount of risk required to stay ahead of inflation could expose you, once again, to the insidious effects of sequence-of-return risk, discussed in my last article.
This is a classic catch-22 scenario that, left unaddressed, could send your retirement balances reeling.
The Retirement Risk Trifecta: In Summary
Longevity risk is a hard riddle to solve because your retirement investment horizon is a complete unknown. Your retirement could last ten years, thirty-five years, or anywhere in between. This much is known, however: the longer you live, the greater the likelihood your retirement gets disrupted by sequence-of-return risk, withdrawal rate risk, long-term care risk, or inflation risk. But don’t despair! I can show you how a truly comprehensive approach to retirement can systematically neutralize all the major risks that threaten to derail your retirement plan.
Want to know more? Schedule a conversation with me today. I look forward to hearing from you!
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