In the last several decades, retirement planning has seen a significant transformation. As a result of enhanced health care, people are living longer, and prices have climbed drastically across the board.
The most significant difference between retirees of yesteryear and those of today is the replacement of defined benefit — or pension — plans with defined contribution plans as a result of the ERISA of 1974 establishing the IRA and the Revenue Act of 1978 establishing the 401(k) (k). According to studies, pensions are and have been swiftly replaced.
Meanwhile, Seniors underestimate their longevity and stock market volatility, and the likelihood of outliving their investments decreases. Adjustments must be performed immediately before irreversible harm occurs.
1. Longevity Risk
In 1950, the average life expectancy was 68.14 years; by 2021, it will be 76.1 years. The COVID-19 virus shortened life expectancy by around 1.2 years, although pensioners live longer. The Society of Actuaries predicts that a pair reaching age 65 has a 50% probability that one spouse will live until age 93 and a 25% chance that one spouse will live until age 98.
The greatest danger for retirees is outliving their savings. Even though no one can predict how long they will live, a 30-year retirement is not as rare today as it was in the past.
Utilizing a three-buck plan is one method for balancing longevity risk. The objective is to distribute funds to meet urgent, near-term, and long-term requirements. A liquid asset can be converted into cash within five years; income assets will be required for 30 years or more; and growth assets are used to offset inflation, taxes, and future health care costs.
In addition, postponing Social Security from the full retirement age to age 70 will generate additional retirement credits at around 8 percent per year, resulting in a higher payment in the future. For instance, if you were born in 1954, you would receive your full benefit at age 66. By waiting until age 70, an extra 32% credit would be available (8% per year for the next four years).
2. Inflation Threat
Inflation is the decline in buying power resulting from a rise in the prices of goods. Since 1914, the average inflation rate has been 3.24 percent, which should remain steady even if the upcoming months’ percentages remain very high. Spending power in retirement is essential, but it may be politicized and overstated, mainly when supply-chain concerns and price gouging are prevalent.
Treasury Inflation-Protected Securities (TIPS) and Series I bonds are suitable hedging instruments against inflation. In 2022, the interest rate on Series I bonds was 9.62%, but only $10,000 per individual or $20,000 per couple could be acquired.
If your risk tolerance does not match speculative or high-risk assets, such as private equity, penny stocks, and alternative investing, you should avoid them.
3. Tax Rates Risk
Under the Tax Cuts and Jobs Act of 2017, the top tax rate was reduced to 37% in 2018, with the remainder of the law due to expire in 2026, including a reduction in the standard deduction and an increase in overall tax rates. Social Security benefits may become taxable if a retiree is still working or has other sources of taxable income, such as a pension, bank or annuity interest, short-term capital gains, ordinary dividends, municipal bond income, or retirement plan withdrawals.
In 2022, if an individual’s combined income is between $25,000 and $34,000 or a married couple’s combined income is between $32,000 and $44,000, up to 50% of their benefits will be taxed. If a person’s combined income exceeds $34,000 or a couple’s combined income exceeds $44,000, up to 85 percent of their Social Security is taxed.
This does not include Medicare Part B rates, which range from as little as $170.10 per month to as much as $578.30 per month in 2022. In 2022, the Medicare Part B premiums for a person with a modified adjusted gross income (MAGI) of $150,000 in 2020 would be $340.20 per month. This amount will change in 2023, although it depends on the individual’s MAGI in 2021.
Converting taxable accounts, such as a regular IRA or 401(k), to a Roth in low-income years and leveraging several tax classes should keep you in a lower tax bracket. Nonqualified annuities offer tax deferral instead of CDs and other bank products, which can assist with both Social Security taxes and Medicare Part B premiums.
4. Health Care Cost
In addition to long-term care, other significant healthcare expenses include insurance, Medicare Part B premiums, medication prices, co-pays, co-insurance, and deductibles. Fidelity estimates that a 65-year-old couple may require around $315,000 (after taxes) to pay their retirement costs in 2022. Taxable accounts are utilized, and the sum may be larger when taxes are included.
Costs are inescapable unless the American healthcare system changes; therefore, it is prudent to be prepared. In retirement, expenses may be lower for some, but the consensus is that they will undoubtedly rise overall.
Contributions to a Health Savings Account (HSA) are tax-deductible, grow tax-deferred, and may be tax-free if utilized for certain medical costs. In 2022, the maximum contribution limits for an individual are $3,650, and those for a family are $7,300. There is an extra $1,000 catch-up payment for those over 55. In addition, eligible HSA funding distribution permits a one-time “trustee-to-trustee” transfer of a person or family’s annual contribution from an IRA or Roth IRA.
5. Cost of Long-Term Care Risk
Long-term care expenses are the most detrimental to a retiree’s savings and investments. As home health care, assisted living, and skilled nursing expenses increase by an average of 1.71 percent to 3.64 percent or more each year, their current prices might easily double or halve by the time you require care.
A Genworth survey conducted in 2021 reveals that, in that year, the average cost of home health care was $61,776, the average cost of assisted living was $54,000, and the average price of a semiprivate nursing home room was $127,538 per person. Home health care should cost around $149,947 in 2051, assisted living should cost approximately $131,072, and a semiprivate nursing home room should cost roughly $230,347.
Insurance salespeople and financial advisors have advised long-term care insurance as a solution for many years. Because premiums are not guaranteed, other forms of “hybrid” plans — such as life insurance and annuities — with long-term care riders can be a feasible alternative. Consider several types of policies, and investigate how each operates.
6. Lifetime Income Risk
Before the 1980s, pension plans constituted a significant portion of a retiree’s income. According to the Bureau of Labor Statistics, this number for private-sector workers has significantly decreased to less than 20%. According to the Pension Rights Center, just 31% of elderly Americans have a pension.
The notion of a “three-legged stool” consisting of pensions, Social Security, and savings was first suggested at a Social Security forum in 1949. The stool comprised pensions, Social Security, and savings. But today’s retirees are sometimes left to figure out the most critical part of building a guaranteed income stream that will not outlive them.
For many retirees, the lack of a fixed income is a significant financial issue. The emphasis of immediate and indexed annuities with income riders is the distribution phase of retirement. Using the same investments during the accumulation phase and failing to rebalance them will increase the likelihood that those assets will not last a lifetime.
The SECURE Act of 2019. permits employer plans, such as 401(k)s, and government plans, such as 403(bs), to access lifetime income benefit alternatives without transferring them to an IRA.
7. Stock Market Risk
As retirees age, their market risk tolerance should decline. The sequence of returns risk is the hazard of obtaining lower or negative returns early on when retirement withdrawals are taken, which can dramatically reduce the total lifetime of the assets.
Since the proposal was initially published in the Journal of Financial Planning in 1994, retirees have employed outdated regulations such as the 4% withdrawal limit. A safe withdrawal consisting of sixty percent equities and forty percent bonds is the best method to avoid running out of money. As a result of low-interest rates, however, this criterion has been questioned, with evidence indicating that it should be decreased from 4% to between 2.95 and 3.3%.
Also, there is an old concept known as the Rule of 120 regarding the ideal portfolio balance by age (previously known as the Rule of 100). It proposes subtracting your age from 120 to determine your portfolio’s optimal stock and bond allocation. For instance, if you are 55 years old and remove 55 from 120, you should have 65% in stocks and 35% in bonds. Timing and allowing human nature to meddle are typically problems with this technique.
Refrain from utilizing obsolete rules to determine your best stock market exposure. Reevaluate your risk tolerance and prioritize savings above the pursuit of greater investment returns.