How to Minimize Risk in Your Retirement Plan
Retirement planning can be an intricate process in all aspects. The place where you settle after retirement, the amount of money you would need in your retirement corpus, the impact of taxes on your retirement savings, and more, are some concerns that are likely to be on your mind when you plan for retirement. Considering the rate of inflation and a rise in needs and wants, it can be extremely challenging to plan a foolproof retirement. There are bound to be certain factors that may never align with your plans and end up being an inconvenience in your golden years. This is why financial experts always suggest investing for a retirement corpus.
Investing can help you bridge the gap between savings, taxes, and inflation. It helps you grow your money at a level of risk you are comfortable with. However, no matter the investments you choose (high risk or low risk), there is an element of risk that will always surround your investments. But the good news is that you can reduce and curtail this risk with some strategies. These strategies can help you cut down your risk and plan your retirement effectively, so you can live your retired years with sufficient funds and no financial worries.
This article talks about how you can minimize risk in your retirement plan.
1. Make the right changes to your portfolio at the right time to be in sync with your current life stage and risk capacity:
Retirement is a long-term process for which you start planning from an early age. If you follow the advice of financial experts, the chances are that you would be saving and investing for retirement from your 20s or 30s. If you retire in your 60s, you would have saved or invested for at least 30 years. This can be an extremely long period. Most people pay attention to their investment technique when they start their journey of retirement planning and revisit it a few years from retirement to check where they stand. They seldom check how their retirement fund is performing against the market in the years between and whether or not their retirement planning methods are in sync with their current risk capacity. This can be detrimental to your corpus in the end. It is important to understand the impact of your investment choices at every life stage. Ideally, when you start investing at a young age, your financial advisor would recommend investing in equities. Even 401(k) retirement accounts have a good percentage of equity funds. Equities can bring in great returns, but they are also susceptible to fall with market changes. If you forget to reallocate your money in other funds over the years, you expose yourself to a lot of risks as you approach retirement. If there happens to be a recession in the years preceding your retirement, you can be left with a reduced corpus. Hence, in order to minimize your risk, you must revisit your investment strategies every few years. At every life stage, you are likely to have a different risk appetite and to have a foolproof retirement plan you must adjust your investments accordingly. This would typically mean moving to more conservative options as you age, especially right before retirement. This way, your money will be safe and you will have a lower chance of having insufficient savings in retirement.
2. Pay attention to when and how you retire to account for decisions in your retirement plans:
The definition of retirement has changed over the years. Most retirees continue to work well past the official retirement age. A lot of people are also considering the FIRE movement – financial independence retire early. While you are free to make these choices as and when you desire, it can help to account for these decisions in your retirement plan too. If you retire early, for instance, in your 40s or 50s, you would not be able to withdraw money from retirement accounts, such as the 401(k) account and the Individual Retirement Account (IRA), without triggering a penalty. Hence, you would have to withdraw from other investments, such as stocks, bonds, mutual funds, etc. Now, if you plan for early retirement from a young age, you would be in a better position to manage your money when you retire. In this case, you would invest in more high-risk investment tools, earn higher returns, and be able to afford an early retirement in your 40s or 50s. However, if you make the decision to retire early at a later stage in your life, you may not have adequate funds in retirement, as your investments may not have garnered sufficient returns by the time you retire. This can put extreme pressure on you. Hence, it is important to plan ahead and pay attention to factors, such as the retirement age, so you can invest accordingly from the very start.
3. Do not depend on Social Security benefits as the only source of income in retirement:
You must think of your Social Security benefits as the cherry on the cake and not the cake itself. While Social Security does add a lot of financial liquidity, it cannot be the only source of income in retirement. In 2021, the average Social Security benefit pay check is $1,543 per month or $18,516 a year. This can be grossly inadequate to cover routine costs, let alone medical expenses, travel expenses, home renovation costs, or financial emergencies. In 2019, Apartment List reported that the average cost of rent in Chicago for a three bedroom house was $1,618. Inflation is only likely to get worse as you age. Hence, assuming that you can live off your Social Security benefits alone, can add a lot of risk to your retirement plan. It is essential to plan for other sources of income for retirement too. Employer sponsored 401(k)s can be an easy choice for most people. IRAs can also offer good returns in retirement. Moreover, these plans let you save systematically and follow a disciplined financial routine. The withdrawal rules and required minimum distributions (RMDs) ensure that you use your money in the right measure and at the right time, making sure that your retirement is comfortable.
4. Diversify your portfolio to minimize risk and maximize returns:
A great way to mitigate risk is to diversify your investment portfolio. When you diversify, you distribute your risk into various assets groups. So, if one investment tanks, the others can balance out the losses. However, even though diversification functions on a simple principle, it can seem a bit complicated when you implement it. Under diversification or over diversification can lead to poor returns and add volatility to your portfolio. Diversification in the wrong asset classes can also adversely affect your returns in the long term. Hence, it may be advisable to consult a professional financial advisor here. Ideally, you can aim to have at least three asset classes to have a well-diversified and balanced portfolio. These include:
- Bonds: Bonds reduce risk from your portfolio by a great margin. The earnings from a bond investment are quite steady with regular interests. Bonds can provide you with a safety net to counter the risk from high-risk Even though the returns may be lower than stocks, they are stable and assured.
- Stocks: This is where you can earn a major part of your investment income. Stocks can offer you high returns over time. But these are also high in risk. They can be highly volatile in nature and can come with their fair share of uncertainties. However, if you add them to your portfolio in the correct measure, you can earn high returns. An important point to note here is to add domestic and international stocks to your investments. Some international stocks perform better than U.S stocks. This increases your chances of earning larger profits.
- Short term investments: These can include tools like money market accounts and certificate of deposits. They add security and offer stable returns. The rate of return is fixed, so there is no element of surprise. You can also use short-term investments as emergency funds.
5. Factor in inflation when you save and invest for retirement:
It is important to plan for the future, keeping in mind the rising prices of goods and services. It is hard to predict how inflation rates are likely to behave in the future. However, in order to have a risk free retirement plan, it is critical to account for high inflation when you save and invest. This will ensure that you do not run out of your savings in old age. Here’s some data from the last few years to give you a glimpse into how inflation rates alter with time:
|Inflation rate for 2016||1.26%||1.14% increase from previous year|
|Inflation rate for 2017||2.13%||0.87% increase from previous year|
|Inflation rate for 2018||2.44%||0.31% increase from previous year|
|Inflation rate for 2019||1.81%||0.63% decline from previous year|
Some financial experts recommend assuming a 3% increase in prices every year while planning your retirement income. One way to tackle this can be to include inflation beating investment products to your portfolio, such as Treasury Inflation Protected Securities (TIPS), real estate, etc. Health insurance, long term care insurance, etc. can also be effective to tackle medical costs. You can renew your plan or increase its coverage with time by paying more premiums. This will cover your health needs despite inflation. You can also take help from a financial advisor to know how to add the expected rate of inflation in the future to your current investment strategies.
6. Be rational with your withdrawals for your retirement needs each year:
Using all of your retirement income in the first few years of retirement can leave you with little to nothing for the latter part. On the other hand, living frugally can result in dissatisfaction and frustration. Hence, it is important to have a sound method to calculate your retirement needs for each year. This can be done by adding all of your income sources and taking an estimate of your total retirement income. You can then use the famous 4% rule strategy. As per the 4% rule, you can withdraw 4% of your retirement corpus in the first year of retirement. You can continue with the same for the next 30 years after adding inflation to the figure. For decades this has been a tried and tested retirement withdrawal technique to ensure that you do not run out of funds in retirement. However, you must keep in mind that this is only a general rule and may or may suit everyone. For people with large estates, the 4% rule can result in higher tax liabilities. Moreover, everyone has a unique set of expenses and can need different amounts of money at different stages in their life. The 4% rule is also applicable to an individual. So, in houses where both spouses are drawing their retirement income, the 4% rule can sometimes result in more money than they have use for. In such a case, it can be beneficial to leave the money for your children or contribute some part of your retirement income to your grandchildren’s college education fund, etc. The 4% rule was also developed by William Bengen in 1994. The socio-economic circumstances were very different back then and so were the nature of expenses.
Hence, it may be advisable to consult a financial advisor when you retire. Depending on the size of your family, your financial needs, future goals, and retirement corpus, the professional can recommend an appropriate withdrawal strategy that can guarantee a financially sound retirement for you and your loved ones.
To sum it up
Retirement planning is a long-term undertaking. You save, plan, and invest for years. Therefore, it is crucial to be practical and make changes to your plan along the way. It also helps to keep a realistic view of your wants and needs in retirement so you can save enough from the very start. Diversification, risk mitigation, keeping a balance between savings, investments, and spending, etc. are critical components of any financial plan. So, it may help to consult a professional financial advisor for personalized advice to make sure you focus on these aspects as you plan your retirement.