When someone is talking about a risk multiplier, they are essentially talking about longevity risk. The longer you live, the more likely it is for you to experience a subset of risks that could completely derail your retirement plan.
There first major risk is the long term care risk. In many ways, you are better off dying than needing long term care, because a long term care event can completely decimate your savings and put your spouse into a very difficult spot.
Historically, long term care policies are how people have mitigated this risk, but these policies have a number of disadvantages. They tend to get more expensive over time, often to prohibitive levels, and it can be very difficult to qualify. People also find the chance of paying for a long term care policy but never using it pretty irritating.
Insurance companies started exploring the idea of giving people their death benefit in advance of their death in the event of a long term care event. This puts people in the scenario where if they die peacefully in their sleep their beneficiaries will get the death benefit completely tax free. This is why the L.I.R.P. is the recommended way of dealing with the risk of a long term care event.
The second major risk is withdrawal rate risk. This risk basically says that there is an ideal amount of money to take out of your stock portfolio each year to avoid running out of money. The previous rule of thumb used to be withdrawing 5%, but that was found to be generally too risky. The current recommendation is somewhere closer to 4%.
The sequence of return risk is closely related to withdrawal rate risk. If you are withdrawing money during a down market in the first ten years of retirement, you could send your portfolio into a death spiral where it never recovers. Combined with withdrawal rate risk, sequence of return risk can really mess with your retirement plan.
The Wall Street Journal is saying the 4% rule is now actually the 3% rule if you want to mitigate your risk. To shield yourself from sequence of return risk and withdrawal rate risk, to fully mitigate them you need to have a massive amount of money saved by the time you get to retirement.
There is another way to mitigate this risk without accumulating a giant amount of money and that is through a guaranteed form of income through an annuity. If you have a pension from your work or are a fan of social security, you are also a fan of annuities because they operate on the very same premise.
If you’re going to live a 40-year retirement instead of a 5-year retirement, then you are much more likely to run into these risks. Take a portion of your stock portfolio and give it to a company that pools your risk with other people’s risk in exchange for a guaranteed stream of income until you die. In the case of a down year, you can avoid taking money out of your portfolio and rely on the annuity instead.
The answer to the three basic risks in retirement are having an L.I.R.P. and an annuity. Mathematically speaking, your money lasts longer, you’re able to spend more money in retirement, you’re able to effectively mitigate longevity risk by having some guarantees in your portfolio.
Longevity risk is the risk multiplier, it will make the other subsets of risks even more likely to derail your retirement. If you want to eliminate stress from your retirement and have peace of mind, then pooling risk and offloading it to insurance companies is the way to do it.