In a prior Thrive Retirement Specialists Insight entitled, "Evaluating the Big Five Retirement Risks Every Retiree Faces," we explored the idea of how the very act of retiring subjects a retiree to five unique risks: 
1) spending risk
2) sequence-of-returns risk
3) purchasing power risk
4) longevity risk 
5) investment risk. 

If you’ve read this insight, you may have now taken the time to understand how each of these risks relates to you and your retirement portfolio. Perhaps you’ve even contemplated your level of willingness and ability to accept each.

But what if there was a way that you could minimize the effect that these risks have on your investment portfolio, and in turn, your retirement lifestyle?

Fortunately, there is!  

Where Does The Process of Retirement Risk Management Fit Into Your Retirement Planning?

Through a combination of certain tools, tactics, and further tradeoff considerations, there are ways you can change your risk exposure profile. This is the process known as retirement risk management. 

A proper retirement plan will seek to manage the risks to which you feel averse to a level you find palatable so that you can feel at ease, thereby increasing the probability of staying on course with the plan. 

As retirement planning specialists, we see that while risk management is an integral part of the retirement planning process, it’s often given too little time and thought.

Big Five Retirement Risks

Let's take a closer look at each of the Big Five Retirement Risks and the tools, tactics, and tradeoff decisions that can be considered as you work to find your optimal risk exposure profile so you can achieve your retirement goals without taking on unnecessary risk.

1) Spending Risk Management

The odds of precisely forecasting your income needs for a long-term retirement are slim. A successful retirement plan should build in some flexibility, especially as you create your retirement spending plan. 

How much flexibility needs to be built into your retirement income planning is contingent upon how well this risk is managed through the following techniques:

• Build a Realistic Budget and Projection
  Building a budget based on and checked against current spending and desired lifestyle decisions is a good start. Included in that budget should be an accurate projection of tax and health care expenses, including healthcare costs in retirement, which can vary widely. Possible contingent expenses should be explored as well to get an idea of potential size, scope, and timing. Lastly, spending flexibility should also be built in to account for the fact the projection will likely be wrong to some extent and to acknowledge the potential for spending shocks.
• Know Your Authentic Goals
  Your authentic goals are much deeper than your stated goals of earning $X amount of dollars per year. Your authentic goals are aligned with the values that truly drive you. You will be less likely to stray off course if your plan expenses and assumptions are consistent with your authentic goals.
• Maintain a Buffer
  A buffer is nothing more than an asset reserve. Certain retirement assets will be used to fund certain retirement plan expenses. Having a buffer, or asset reserve, set aside to fund contingent expenses will allow you not to take from assets dedicated to funding other retirement expenses. Having other assets outside the portfolio that you can draw on will help keep other areas of your plan on track by not reducing assets funding those other goals.
• Frequent Plan Update and Review
  Because there are so many changing variables and assumptions that feed into a retirement plan, updating and reviewing your plan on a regular interval is key to keeping you on track. Updates allow you to incorporate recent history and tweak variables and assumptions as needed to see if any action needs to be taken before you end up too far off course, requiring some drastic action or lifestyle change to get back on course. In this case, comparing actual spending to budgeted spending would be in order.

2) Sequence-of-Returns Risk Management

Sequence-of-returns risk is the risk that your investment portfolio will be down when you start withdrawing assets. 

While sequence-of-returns risk cannot be eliminated, it can be reduced and managed through some combination of the following techniques:

• Maintain a Buffer
  Having other assets outside the portfolio that you can draw on during a financial market downturn helps to avoid/minimize selling from the investment portfolio at a loss.
• Employ a Dynamic Withdrawal Strategy
  Maintaining flexibility in the amount of one's spending allows one to take less income from the investment portfolio during a financial market downturn, reducing reliance on the portfolio during down periods and helping to manage sequence of returns risk in retirement.
• Reduce Portfolio Return Volatility
  Investment portfolio return volatility can be reduced through proper portfolio construction and the asset allocation decision. A properly constructed portfolio of low-cost, broadly diversified index funds combined with the overall level of stock and bond exposure can be used to control the range of possible return outcomes. Investment philosophy, asset allocation, portfolio construction, and portfolio management all matter a great deal.
• Reduce Reliance on Investment Portfolio
  The more your fixed expenses can be funded by fixed sources of income, the better. The primary source of fixed income for most retirees will be Social Security, which is why having a proper claiming strategy in place is so important. Other fixed sources of income could include payments from a defined benefit pension plan or an annuity that is owned or can be purchased.
• Control the Controllable
  Returns can vary due to reasons outside your control, such as poor economic conditions, but they can also vary due to factors within your control. Unfortunately, many retirees hurt themselves unintentionally through actions of their own that lead to below-market returns. These actions include paying too much for advice/investment management, poor investment selection or timing, poor portfolio construction, and failing to recognize behavioral pitfalls.

• Frequent Plan Update and Review
  A retirement plan that relies on an investment portfolio for a significant portion of income can be sensitive to market returns. As a result, regular updates that incorporate recent performance allow you to stay on top of potential sequence-of-returns risk so you can act right away and make small changes along the way.

   

3) Purchasing Power Risk Management

Purchasing power risk (also known as inflation risk) is the risk that the value of money will decrease over time due to inflation, reducing the purchasing power of your assets or income. While there is nothing that can be done directly to affect the inflation rate, there are some ways to reduce the unknown it casts over a retirement plan and to help mitigate its effect. 

Following are the primary purchasing power risk management techniques:

• Proper Investment Portfolio Construction
  There are certain asset classes that can be included in your investment portfolio that can reduce your purchasing power risk by directly hedging against inflation or increasing in value as a result of inflation, thereby offsetting its negative effect. Click here to learn how you can build an optimal retirement investment portfolio.
• Asset Allocation Decision
  The proportion of the investment portfolio allocated to riskier but higher-return potential assets like stocks versus less risky but lower-return potential bonds can play an important role by helping the overall return of the investment portfolio stay above the rate of inflation.
• Make Changes to Spending
  A retiree could decide to spend less as they get into the later years of retirement by spending less on discretionary items like travel and leisure. This, of course, presumes the discretionary spending savings do not need to be reallocated to other expenditures that can increase as one ages, such as health care. Another way to reduce spending is to reduce the proportion of expenses that are more sensitive to inflation. For instance, one could trade in a larger home for a smaller one to reduce the monthly expense for property taxes, utilities, homeowner's insurance, and maintenance.
• Increase Sources of Inflation-Adjusted Income
  Social Security has an annual cost-of-living adjustment based on the Consumer Price Index (CPI). Delaying social security as long as possible is also a way to protect against inflation risk. As benefits increase to age 70, a larger percentage of the individual's retirement income plan will be inflation-protected. 
• Frequent Plan Update and Review
  The inflation assumption is a key assumption made in a retirement plan. Regularly reviewing the retirement plan and updating the inflation assumption as needed will serve to identify any potential issues so you can make corrections before they become an issue.

4) Longevity Risk Management

Of all the risks, longevity risk in retirement is probably the most puzzling. How is a retiree supposed to maximize their spending during their retirement years but not run out of money if they do not know how long their retirement will last? 

Fortunately, there is a mix of tools, tactics, and tradeoffs that can be used to manage longevity risk to the extent a retiree feels necessary. Following are some of those techniques:

• Increase Sources of Guaranteed Income
  Social Security will likely be your primary source of guaranteed income. You will continue to receive social security payments as long as you live. You may also have the benefit of a defined benefit pension plan that pays guaranteed income until you pass. Insurance annuity products can be purchased in some proportion and can pay either an immediate stream of income or a stream of income at some future date. Insurance companies can pool longevity risk over many individuals, giving them the ability to project more accurate and consistent mortality results. This allows insurance companies to insure against longevity risk at a cheaper rate than an individual who chooses to self-insure.
• Increase Your Planning Horizon Assumption
  Increasing the mortality assumption will reduce your sustainable withdrawal rate but will allow your retirement assets to fund your retirement over a more extended period with less risk.
• Flexibility on Discretionary Spending
  The ability to lessen discretionary spending later in life if needed can help to extend your retirement assets' ability to fund your fixed living expenses.
• Frequent Plan Update and Review 
  As your retirement progresses, it will be important to monitor your retirement spending and your asset depletion rate. Adjusting your plan based on real-time data will allow you to make corrections as you near your life expectancy or see if certain assumptions need to be revised.

5) Investment Risk Management

This is an area most people want to control but have very little ability to do so, especially with external market conditions. 

The best way to manage investment risk is to reduce exposure to market volatility through a thoughtful asset allocation strategy when creating your retirement investment portfolio.

• Portfolio Diversification
  Diversifying your investment portfolio across asset classes, industries, and geographies helps to reduce risk and volatility, ensuring that market downturns do not negatively impact your ability to retire comfortably.
• Dollar-Cost Averaging
  By contributing to your investment portfolio on a regular schedule, you can avoid trying to time the market and reduce the impact of short-term market fluctuations.
• Frequent Plan Update and Review
  Regular reviews of your investment portfolio allow you to assess its alignment with your retirement goals and make adjustments as needed to ensure long-term growth and stability.

Risk Management is an Ongoing Process

The tools and tactics an individual will use and the tradeoffs they will be willing to make will be unique to each individual given their risk exposure profile, attitudes toward the various risks, and available resources. 

As time passes, part of what was once forecasted becomes actual. Assumptions can change and become more refined. People's lifestyles, spending patterns, and health can change. So too can their risk exposure profile, willingness, and ability to accept the various Big Five Retirement Risks. 

Just like in a proper retirement planning process, (see Thrive Retirement Specialist's Insight entitled "Steps That Should Occur in a Proper Retirement Planning Process") you should continue to monitor and formally revisit your risk exposure profile and reassess your willingness and ability to take the various risks you will be subjected to in retirement.

The more risk you want to remove and manage, the more tradeoffs you must make in benefits elsewhere. Whether spending risk, longevity risk, sequence-of-returns risk, or purchasing power risk, managing risk can be expensive. 

But you must be honest with yourself and how you feel about each of these big five retirement risks. If you are not, you can face two potential consequences. The first is to live in fear or to become regretful. The second risk is veering from your plan at some point and thus jeopardizing the sustainability of the plan long-term. Neither of these situations is ideal and can both be avoided through proper risk management planning.

Risk management is an ongoing process and we're here to help. If you have any questions, please feel free to reach out.

FAQs About the Big Five Retirement Risks

1. What are the five biggest risks in retirement?

The five biggest risks in retirement are spending risk, sequence-of-returns risk, purchasing power risk, longevity risk, and investment risk.

2. How can I manage spending risk in retirement?

You can manage spending risk by creating a realistic budget, setting aside a buffer for unexpected expenses, and updating your plan regularly.

3. What is sequence-of-returns risk, and how can I manage it?

Sequence-of-returns risk refers to the timing of market returns and its effect on a retirement portfolio. To manage it, maintain a buffer, use a dynamic withdrawal strategy, and reduce portfolio volatility.

4. How can I protect against inflation in retirement?

You can protect against inflation by investing in assets that appreciate with inflation, adjusting your asset allocation, and considering inflation-adjusted income sources like Social Security and annuities.

5. What is longevity risk, and how can I manage it?

Longevity risk is the risk of outliving your retirement savings. You can manage it by increasing sources of guaranteed income, adjusting your planning horizon, and remaining flexible with discretionary spending.