Retirement Plan Or Investment Plan?

by: Dirk Cotton

My last few posts have explained that outliving retirement savings as a result of sequence of returns risk isn't the worst thing that can happen to a retiree. Becoming insolvent as the result of unexpected and uncontrollable expenses is significantly worse, though less likely -- less than half a percent of Americans over age 65 declare bankruptcy.

I also recommended that a comprehensive retirement plan address all known financial risks and not simply the risk of outliving our savings due to market volatility and overspending. In this post, I want to suggest what those other risks might be (by reviewing reasons that people over age 65 typically file for bankruptcy and adding a couple of risks of my own), and some potential ways in which planning might mitigate (lessen the severity) or even insure against them.

Becoming insolvent (unable to pay your debts) and declaring bankruptcy are not the same thing. Declaring bankruptcy is a legal action that might help deal with insolvency, depending on the specifics of your situation. Whether or not it is the best alternative is something you would want to discuss with a bankruptcy attorney, should you ever need to consider it.

(In this post, I am discussing the risk of insolvency. In previous posts, I used bankruptcy statistics from the U.S. Court system. It's important to distinguish between the two.)

Given that I described spending crises as chaotic, synergistic (in a bad way -- they combine to have a greater negative impact that the sum of their parts), unpredictable, and difficult to stop once they begin to spiral downward, it might seem that there would be little to be gained from planning, but that isn't the case.

Certainly, there are some spending crises that would completely overwhelm nearly anyone's personal finances (a spinal cord injury, for example, could cost millions), but there are many crises that can be mitigated with the right planning. Let's start by recalling the 10 most common causes of elder bankruptcies:

  • Credit Card Interest and Fees (67%)
  • Illness and Injury (65%)
  • Income Problems (41%)
  • Aggressive Debt Collection (35%)
  • Housing Problems (27%)
  • Divorce (15.1%)
  • Birth or adoption of child (9.7%)
  • Death of family member (7.5%)
  • Retirement (6.7%)
  • Identity Theft (1.9%)

Recall that the major causes were self-reported and that most respondents to the survey reported multiple causes, so the percentages total more than 100%.

In Retirement and Chaos Theory, I suggested that insolvency behaves like a fixed point attractor. Our finances can develop a positive feedback loop and spiral downward to that point if they enter into insolvency's "gravitational field." Sometimes, it's nearly impossible to avoid ruin once that process begins.

One way to mitigate that risk would be to stay as far away from insolvency's region of influence as possible, avoiding the risk of going broke like avoiding the gravitational field of a black hole. Consumer credit, inadequate insurance, and financial dependence on a spouse, for example, move you closer to insolvency's gravitational pull.

Let's look at those risks, chaotic though they may be, and show that there are ways we can plan for them.

Credit card interest can be deadly and research shows that typical credit balances continue to increase throughout retirement. Retirees can plan to pay off all consumer (non-mortgage) debt before they stop working and to control credit use after retiring by sticking to a solid retirement spending plan.

Most retirees will be eligible for Medicare when they turn 65, but Medicare doesn't pay all of our medical costs. Fidelity Investments has been tracking retiree health care costs since 2005 and estimates that a 65-year-old couple retiring in 2015 will need $245,000 to cover future medical costs, not including the cost of long-term care.

That's more than most households save for retirement. It will devour a large portion of Social Security benefits for many. Retirement plans shouldn't ignore this risk.

We might consider planning to retire to a state with low health insurance costs, lower long-term care costs, and lower medical costs, but we should also consider the quality of care available.

Income problems cited in the studies were primarily the result of either age discrimination leading to unplanned early retirement or medical problems leading to unplanned early retirement. In some cases, unplanned early retirement was necessary to take care of a family member with a medical problem.

A retirement plan can assess the risk of unplanned retirement in our profession. Optometrists can work longer than oil field roughnecks. We can also assess our own health risks and the health risks of others who might need our care. These observations might lead us to the conclusion that we need to plan to find a job where we are more likely to be able to work to an older age, even if it pays less, or that we need to increase our savings, or lower our retirement income expectations.

Foreclosures soared in 2007 and they are particularly damaging to seniors. Foreclosure risk can be reduced by relocating to an area with less expensive housing, for example, or by planning to pay off (or pay down) a mortgage before retirement.

Believe it or not, one can purchase divorce insurance, though that doesn't seem like a great way to deal with the devastating risk of elder divorce. A comprehensive retirement plan will model our financial risk of a divorce at various ages and can show the impact that a break-up would have on each spouse. E$Planner software can provide such contingency plans, for example. This analysis may provide insight into ways our retirement plan might be adjusted to improve outcomes for both spouses.

As with elder divorce, the impact of the death of a spouse at various ages can be modeled in a retirement plan. Life insurance, however, works much better than divorce insurance and software like E$Planner can calculate the amount of life insurance that will be needed at various ages. It can also model the impact of that death on Social Security benefits.

The final cause for bankruptcy cited by the Institute for Financial Literacy is identity theft (1.9%). I have previously recommended placing a freeze on your credit report.

Although lawsuits don't appear to be major contributors to elder bankruptcy, I'm still fond of umbrella liability insurance.

Do you have a child or parent with health issues? Legal or medical costs could break your retirement plan and need to be considered.

Lastly, if you can't avoid bankruptcy, there are steps you can take to protect assets. Holding assets in a retirement account will usually protect them from creditors. Future Social Security benefits are also protected. Even Social Security benefits that you have already received can be protected in bankruptcy if you hold them in a separate account that is only funded by those benefits. Commingling them with other funds can expose them to creditors.

The following list of insolvency risks is not comprehensive (though all but the last two risks were identified in a study as the top causes cited for elder bankruptcy). Nor is my list of possible strategies to mitigate them by any means complete. The key point is that it is important to identify the major financial risks in your retirement plan, to quantify them, and to identify ways to mitigate them, if possible. If mitigation is not possible, it is important to understand the risks if for no other reason than to avoid overconfidence in your plan. Far too many retirement discussions focus primarily on market risk.

Risk Potential Mitigation or Insurance
Credit Card Interest and Fees Pay off consumer debt before retiring
Illness and Injury Relocate for lower medical costs, Medicare, Health Insurance
Income Problems Change to a more sustainable job, evaluate your household's health risks
Aggressive Debt Collection Understand your rights
Housing Problems Pay off mortgage before retiring, relocate
Divorce Develop retirement financial contingency plans for divorce
Birth or adoption of child
Death of family member Develop financial contingency plans, life insurance
Retirement Evaluate your prospects for continued employment
Identity Theft Educate yourself, keep current on identity theft scams and freeze your credit report
Fraud Educate yourself and keep current on elder fraud
Financial needs of parents and children
Legal liability Umbrella liability insurance

A good place to start would be to list the risks to which you have significant exposure from the table above, add any other risks that might apply specifically to you, and then check to see if they are considered in your current retirement plan. If not, then you (or your advisor) have more work to do.Does your retirement plan consider these common causes of insolvency and plan for them? If it mostly tells you how to invest your savings and how much of your portfolio you can safely spend each year then you don't really have a retirement plan.

You have an investment plan.