How to Manage Risk in Retirement

Longevity Risk
One of the common concerns I hear from people approaching or in retirement is the fear of running out of money too soon. It's tough (okay, impossible) to know just how long a life expectancy you should plan for. When I run retirement projections for people, I'm now using age 97 as the default life expectancy. If I know that long lives run in a client's family, I may shift this even further out. For example, I have one client whose mother is 101 and going strong. So we built a very long life span into my client's future planning, too.

When you're planning for your retirement years, you'll want to err on the conservative side of life expectancy, meaning that you should plan as though you're going to live to a ripe old age. When you look at tables showing average life expectancies based on your current age, remember they are just averages.

You probably want to add several years to the average to account for a higher-than-average life expectancy. You also want to consider the advances in medical care not only now but into the future. It's really not unusual to see people living into their late 80s and 90s today. Statistics also show that if you are married, you should add on even more years.

Let's look at an example. For a couple aged 65 and about to retire, there is a 50% chance that one of them will live to age 91 and a 25% chance that at least one of them will live to age 96. That's more than 30 years of retirement to finance. Look at your own family history. That's the best indicator of what your genes have to say about longevity. But remember too that with medical advances, you may very well live longer than your parents and grandparents did.

Historically, women have lived longer than men. That may be changing somewhat as women have entered the workforce in greater numbers and are subject to many of the same risk factors as their male counterparts. However, in general, women should plan for a longer life expectancy than men. You also need to factor in women's longer life expectancies if either of you has a pension plan that allows you to choose a single life annuity or a joint and survivor annuity. In most cases with married couples, you'll want to choose the joint and survivor annuity, which will cover both spouses' lives. Many annuities have "pop-up" features that allow the annuity payout to pop up to the higher single life annuity amount should one spouse die prematurely. If you have a pension plan at work, you should investigate if this is an option you can choose at retirement.

There are protections you can put in place to guard against longevity risk. One is purchasing or electing an immediate annuity. If you have a pension plan that offers annuities, choose the option that insures both lives. That will guarantee (as long as the insurance company is solvent) that you won't outlive your income stream. If you don't have a pension plan, you can still purchase an immediate annuity. It's not necessary to purchase an immediate annuity to cover all of your expenses. Perhaps you can just cover your fixed expenses. You may still want a portion of your portfolio invested in stocks for growth. Also consider purchasing inflation coverage if you buy an immediate annuity. That increases the amount you get in your check each year and eliminates one of the downsides of an annuity.

To sum up, give some thought to what life expectancy is not only reasonable, but practical given your personal family history and your current health. Err on the side of too long rather than too short. Consider an immediate annuity to address outliving your assets.

Spending Risk
If you read lots of retirement surveys, as I do, you'll see patterns and trends. People are living longer in general and spending more money in retirement than previous generations. In particular, people are spending more on gasoline, entertainment, travel, and health care.

When you think about your retirement years, you may find it helpful to divide them into two stages: your younger retirement years, when you want to be more active, and your older years, when physical limitations may prohibit a more active lifestyle and your health-care costs will likely increase. You need to plan adequately for both of these stages. It used to be that planners talked about an income-replacement ratio of 70% to 90% to cover retirement living expenses. I rarely reduce my clients' projected living expenses simply because they'll be in retirement.

Most of my clients expect to spend about the same, or perhaps even more, in retirement than they do now. That's because they want to travel, play more golf, or spend more time on hobbies. One way of thinking about expenses is to group them by essential (fixed) costs and lifestyle (discretionary) costs. I like the idea of using an immediate annuity to cover the fixed costs. You could also do the same thing with assets like Treasury Inflation Protected Securities. You would just purchase enough TIPS to generate interest equal to your fixed expenses. Unlike other bond types, TIPS have the advantage of never falling behind inflation. While we're not seeing much inflation now, I doubt that will always be the case.

Don't forget to budget for the one-time big expenses too--like new cars periodically or special trips you've been planning. Many people also want to make sure that there is something left to pass on to their children or grandchildren. Any of these factors will mean that you may need to adjust your level of spending in retirement. And let's not forget about health-care expenses. The Employee Benefit Research Institute estimates that a couple (with both spouses age 65) could require as much as $295,000 to cover health insurance premiums and out-of-pocket expenses if they live to their life expectancy. If they live to age 95, that number jumps to $550,000.

This high cost of health-care comes at a time when a record number of employers are cutting back their retiree health-care insurance coverage. The percentage of large employers (those with 200 or more workers) that offer retiree health-care coverage has been decreasingfrom 66% in 1988 to just 35% in 2006. And don't think your former employer can't cut your health-care coverage once you are already retired. I've seen that happen.

Although we aren't seeing a large increase in inflation overall, there is marked inflation in health-care costs. Studies show that while the annual overall inflation rate from 1987 to 2006 is 3.1%, the health-care inflation rate is 5.1%. Careful planning long before you retire can help address this risk before you find yourself awash in medical bills.

No discussion of the spending risks in retirement would be complete without touching on the cost of long-term care. Home health care is a popular option that is increasingly covered by long-term care insurance. According to a paper distributed by the National Bureau of Economic Research, 44% of women and 27% of men aged 65 should expect to spend some amount of time in a nursing home. This research also shows that the average stay for a woman is two years and for a man is 1.3 years. But patients suffering from Alzheimer's often require as many as eight or more years of assisted living and/or nursing home.

According to the MetLife 2006 Survey of Nursing Home and Home Health-Care Costs, the average rate for a private room in a nursing home is about $200 a day or about $75,000 a year. As you think about countering the risk of spending in retirement, there are several things you can do to protect yourself:

Run your retirement projections out to a reasonable life expectancy. Plan for a longer-than-average life.

Add up what you're spending now if you are about to retire or if you are in retirement. Remember to include less frequent expenses like travel, cars, and real estate taxes. Plug those expense numbers into your retirement projection to see how long your assets last.

Try to generate enough income from fixed sources (like TIPS or an immediate annuity) to cover fixed costs.

Make sure your retirement budget has adequately prepared for health-care costs in retirement, which may include long-term care.

A version of this article appeared in the July 2007 issue of Morningstar Practical Finance.