Friday, May 25, 2012

Pre-Retirement Risks

10:09 AM


Pre-retirement Risks or What Can Derail a Retirement Plan
“There is always risk in the stock and bond markets. Risk is the source of returns. The greater the risk, the higher the expected return.”

Dan Solin, A Rational Response to Irrational Market Anxiety
I will discuss today the many hazards that can occur before we hang our hat and decide to retire.

Honey I’m retired

For many of us, retirement does not start the day after our retirement party. We gradually reduce the work portion of our life and replace it with more of the leisure portion. We may leave our last nine to five job and start our own business, working part-time or on a contractual basis. The next thing you realize is that you actually have started your retirement. This situation provides a nice transition, but has to be managed with solid planning.

The more common situation is a loss of employment, or reduced employment, and the unpredictable nature of it is harder to manage. How can we prepare for this? We need to bridge the period between this forced retirement and the actual planned retirement age.

We need to ensure we won’t suffer devastating investment losses by investing more conservatively. We also can plan our income and expenses for the next few years and determine how we can meet our budget with severance, early retirement company pensions, Canada (or Québec) Pension Plan and whether we can find part-time or contractual work.

If income is insufficient and expenses cannot be reduced further, we can look into updating our skills to areas that are more in demand. If this is not possible, then we may need to start drawing from invested assets. In years of low or no income, it may make sense to withdraw from an RRSP, as the tax on these withdrawals will be minimized.

The date choosing you

There are two other circumstances that can give rise to a forced retirement: health issues and disability. Declining health prevents us from working among other activities and is expensive with the cost of care and drugs. The cost side can be managed with personal health insurance, but the loss of income has to be compensated by a reduction of expenses and withdrawal from invested assets.

Disability is also a health issue, but it can be managed with disability insurance. Workplace benefits always include a long-term disability plan and you should purchase it. If not available, personal disability insurance may be an option, although premiums for individuals are higher.

Savings setback

Over the long-term, equity markets have historically delivered solid returns, and we can cautiously expect this to continue. In theory, we take more risk to achieve greater returns. Equity and bond markets are volatile, that is, returns are not stable. So we may – and do – experience regularly a few bad years in a row, followed by good or spectacular returns.

A few years of bad returns may occur at exactly the wrong time: just before retirement. For example, if your investments dip by 20%, then you probably should cut back withdrawals during retirement by 20%.

In the last few years, segregated funds with a guaranteed minimum withdrawal benefit (GMWB) sold by insurance companies have been quite popular. In exchange for higher fees, a guaranteed minimum income of 5% of assets is payable for life. This provides a safety net against devastating market losses. Two comments on GMWB: if you stay invested for the long-term and ride out negative years, the guarantees will not likely come in play. Also, several insurers have exited this market, because of lack of profitability and heavy capital requirements. Nevertheless, where available, they do provide protection and may have a role in your retirement product allocation.

How do we deal with this?

First, we have to gradually move to a more conservative portfolio. This concept is embraced by “target date funds”, but beware of the wide range of equities at the retirement stage between funds. In any case, lowering equities will reduce volatility and expected returns. But we can achieve more stable returns and reduce or eliminate the possibility of a devastating loss.

The years just before and following your retirement date are no time to gamble.

Save more

If you do experience negative investment returns, you can tighten your belt and save more. This will be easier if you can control your expenses and eliminate unnecessary spending.

Stay invested in the markets

Throwing the towel and getting completely out the markets will prevent you from earning good returns when the bull market comes back.

Diversify

Diversifying investments among asset classes is a good idea, but is less effective in down markets because all equity markets tend to become highly correlated. But a well-diversified portfolio will reduce the overall volatility of your investments. 

Plan what you’ll need

Plan what you’ll need for retirement so you know what you need and what it takes to get to you goal. You can make a post-retirement budget and find the right balance between what you wish and what can be realistically achieved.

Work more

If you can, find other part-time contractual work to complement your income and send this money directly to savings.

Defer

If you are eligible to receive a pension from the Canada (or Québec) Pension Plan or a employer-sponsored defined benefit pension plan, consider deferring commencement to the time you get an unreduced pension. Early retirement reductions can be significant working a couple more years lets you earn income and save for retirement and enjoy a full pension when you retire.

“Safe as Houses”

For many, a lot of our net worth is tied to the value of our house. It make sense when children are gone to move to a smaller house or apartment and free up the leftover capital as a source of retirement income. If you get less than expected, this may affect your future standard of living. You may need to be flexible and adjust your expectations or wait for a recovery. Bear in mind the seasonal nature f real estate sales, with the spring being more often a seller’s market.

Throwing a monkey wrench

When all is well and working according to plan, Murphy’s Law rears its ugly head: if anything can go wrong, something will go wrong sooner or later.

Unforeseen expenses such as major renovations or medical issues can be quite costly. There is also the possibility of having to take care of family members in need: aging parents requiring assistance and children, and the time and expense associated with this.

The best way to deal with this is to keep an emergency fund, held in liquid investments to cover the eventualities that could apply to you.

Sad notes

Planning retirement involves both spouses of a couple, even if one retires before the other. If a change occurs in marital status, then the plan has to be redrawn based on each spouse going forward with its share of the family assets. Being single again means that a lot of expenses previously shared will have to be assumed by each, such as housing, car, vacations, etc.

Here’s my second sad topic: death of your spouse. Having the right amount of life insurance is essential to ensure that neither suffers a financial setback on top of a devastating loss.

If one or both is uninsurable, then having a will that minimizes income tax will maximize the assets available to the other spouse. At this point, a change in housing to a less expensive dwellings and investing the difference for future retirement income makes sense.  

Young retirees need more

One last thing, the younger you retire, the more money you’ll need. Retiring early needs careful planning: you have to know how long your money will go and how your sources of retirement income and assets will fit together to meet your retirement budget over the long term.

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