Retirement Income Risks
This quarter’s topic addresses several risks when it comes to your retirement income. It’s not uncommon to overlook some of the factors that can affect how much you’ll have available to spend. For example, consider how your retirement income can be impacted by investment risk, inflation risk, taxes, and catastrophic illness or long-term care that may keep you from enjoying the retirement you envision. In this article, we will look at those first three areas.
Different types of investments carry with them different risks. Sound retirement income planning involves understanding these risks and how they can influence your available income in retirement.
Investment or market risk is the risk that fluctuations in the market may result in the reduction and/or depletion of the value of your retirement savings. If you need to withdraw from your investments to supplement your retirement income, two important factors determine how long your investments will last — the amount of the withdrawals you take and the growth and/or earnings your investments experience. Unfortunately, the market doesn’t always generate positive returns.
Reinvestment risk is the possibility that proceeds available for reinvestment must be reinvested at an interest rate that’s lower than the rate of the instrument that generated the proceeds. This could mean that you have to reinvest at a lower rate of return, or take on additional risk to achieve the same level of return. This type is often associated with fixed interest savings instruments such as bonds or bank certificates of deposit. When the instrument matures, comparable instruments may not be paying the same return or a better return as the matured investment.
Interest rate risk occurs when interest rates rise and the prices of some existing investments drop. For example, during periods of rising interest rates as predicted here in 2015, newer bond issues will likely yield higher coupon rates than older bonds issued during periods of lower interest rates, thus decreasing the market value of the older bonds. You also might see the market value of some stocks and mutual funds drop due to interest rate hikes because some investors will shift their money from these stocks and mutual funds to lower-risk fixed investments paying higher interest rates compared to prior years.
Inflation is the risk that the purchasing power of a dollar will decline over time due to the rising cost of goods and services. If inflation runs at its historical long-term average of about 3%, the purchasing power of a given sum of money will be cut in half in 23 years. If it jumps to 4%, the purchasing power is cut in half in 18 years.
The effect of taxes on your retirement savings and income is an often overlooked but significant aspect of retirement income planning. Taxes can eat into your income, significantly reducing the amount you have available to spend in retirement. It’s important to understand how your investments are taxed. Some income, like interest, is taxed at ordinary income tax rates. Other income, like long-term capital gains and qualifying dividends currently benefit from special—generally lower—maximum tax rates. Some specific investments, certain municipal bonds, for example, generate income that is exempt from federal income tax altogether. You should understand how the income generated by your investments is taxed in order to factor the tax into your overall projection.
Taxes can impact your available retirement income, especially if a significant portion of your savings and/ or income comes from tax-qualified accounts such as pensions, 401(k)s, and traditional IRAs. Most, if not all, of the income from these accounts is subject to income taxes. Understanding the tax consequences of these investments is important when making retirement income projections.
Have you planned for these factors?
During retirement, revisit these common factors that can affect your income and savings. While many of these same issues can impact your income during your previous working years, you may not notice their influence because you’re not depending on your savings as a major source of income. However, investment risk, inflation, taxes, and health-related expenses can greatly affect your retirement income.
Orchard Alliance is here to serve and help. Please feel free to contact us.