There is a pretty long list of elements people commonly forget to consider in their retirement savings effort, David Blanchett, head of retirement research for Morningstar, tells PLANADVISER.
“First, I think there is still a serious misunderstanding of life expectancy that exists today—especially how life expectancy will change in the next 20 or 30 years, as that will impact even the older generations of people in the 401(k) system right now,” he says.
As Blanchett observes, most people understand that modern medicine continues to improve the average length of peoples’ lives, but few understand how truly significant this is from a financial planning perspective. Even a five-year boost in life expectancy for an individual at 65 dramatically increases lifetime income needs.
“It’s really important for people to ask themselves not just, ‘Will I be able to retire?’ but also, ‘Can my nest egg last 30 years?’” Blanchett says. “It can be a difficult question to think about, because in a lot of cases the answer is going to be no.”
Additionally, Blanchett feels relatively few people understand what it means to have a 20- or 30-year life expectancy at 65. “People often think, my life expectancy at 65 is 20 years, so I should plan for a 20-year retirement,” Blanchett notes. “However, they forget or they just don’t understand that life expectancy is an average. So with a life expectancy of 20 years, that means there’s actually a 50% chance that you will live longer than 20 years.”
Blanchett even suggests that people who spend a whole working lifetime contributing to a 401(k) are also more likely to be in the 50% of people who live beyond their stated life expectancy.
“It’s not an exact statistic, but the other thing is that people who have saved in a 401(k) plan successfully are not average Americans,” he says. “When you look at the data, consistent retirement plan participants tend to be somewhat healthier and wealthier than people on average, which has a positive impact on longevity.”
Blanchett says many people plan to address these issues simply by working longer, but it’s also commonly overlooked that people are bad at predicting how long they’ll be able to stay in the full-time work force. For example, a recent EBRI study found that, in 2012, the expected probability of working full-time after age 65 among men and women then working full-time was 48.7% and 46%, respectively. However, only 12.7% of men and 6% of women actually worked full-time after age 65 during that year (see “Great Recession Shifted Retirement Expectations”).
“I frequently see research showing that the actual age of retirement is ticking up, but it’s still about three years less than the expected age of retirement,” Blanchett says.
Interestingly, the gap between individuals’ expected and actual retirement dates has remained consistent as the actual age of retirement increases. “So there is a really good chance that a lot of those people out there in the job market right now who are planning to work until age 67 or later will more likely retire at or before age 64,” Blanchett says.
The difference of a few years may seem minor, he notes, but it can have a huge impact on a person’s ability to retire successfully and make a limited pool of assets last. “It’s an important question for people to ask, and one which they don’t ask very often: 'What happens to my plan if I’m forced to retire five or even 10 years earlier than I expected?'” he explains.
Further complicating the problem, Blanchett says, a lot of people back-load their savings effort and plan to make up for lost ground late in their career, when they expect to be earning their highest wages. “But what happens to this outlook if you learn at 55 that you can’t work anymore?” he asked, “or that you have to shift to a part-time position?”
Another piece of the retirement planning picture that often gets overlooked is the “sequence of return” risk associated with retirement portfolios. Put simply, the sequence of return risk arises from the fact that an individual has to leave the workforce at some specific point and begin drawing on accumulated assets. This can be a major problem if the anticipated retirement date comes during a deep market trough, as occurred during the Great Recession, when many retirement savers saw more than 20% or 30% of their portfolios evaporate in a short period of time.
This type of late-carrier portfolio drop puts investors in a really difficult spot, Blanchett notes, as they’re essentially forced to choose between delaying retirement or trying to live with a smaller nest egg. Worse, dollars withdrawn by retirees when portfolios are depressed in value never have a chance to rebound when markets pick up again. The problem is unfortunate and not an easy one to address, according to Blanchett.
“Some people think converting to a cash portfolio might be the answer here, but cash isn’t exactly safe either,” he says. “An all-cash portfolio right now is essentially posting a negative rate of return after you factor for inflation. And if you’re earning a negative rate of return after inflation for the first 10 years of retirement, you’re never going to make it over the 30 year retirements we’ve been talking about. You're inevitably going to have to take on some amount of risk.”
Blanchett adds there is also a tendency to overlook the fact that bond holdings are subject to sequence risk as well, and may not always be a safe investment.
“Bonds have really been reliable over the last 30 or 40 years, but things are different today,” he says. “We are at a challenging place where the expected return on stocks is relatively low versus historical averages, and yields on bonds are low as well. It really highlights the importance of a well-diversified portfolio.”
On the plus side, Blanchett says, individual retirement savers seem to be getting a better handle on just how much they should expect to spend on health care in their post-work years. But he questions whether studies showing a typical couple can expect nearly $300,000 in out-of-pocket medical expenses in retirement paint an accurate picture of what causes financial hardship in retirement.
“I’m always a little leery of studies like that, which come out with a big headline number about the cost of X or Y in retirement, because you could do the same thing for items like food, clothing, even the heating bill or transportation,” Blanchett says. “Over a 30 year retirement all of these are going to be very significant expenses.”
The point is that getting too focused on one piece of the retirement picture—be it health care or housing—may be problematic, he explains.
“What really matters is the total batch of money and the income that you, as the individual, are carrying into retirement,” Blanchett says. “While health care costs pretty reliably go up as the individual moves into and through retirement, many of their other recurring expenses go down, so there is an offsetting that happens. The example is that you will probably be paying for more prescription drugs at age 85 than you did at 35, but you’ll also likely be traveling less and just spending less in general. “
Another problem in retirement health care cost planning is that one member of a married couple usually outlives the other—sometimes by quite a significant margin.
“One of the worst things that can possibly happen in retirement for a couple is if, say, the male spouse enters a nursing home at age 70 and the couple doesn’t qualify for Medicaid or any long-term care relief,” Blanchett notes. Even if the male spouse only lives to 73 or 75 in the nursing home, the couple will pay up to $100,000 a year in out-of-pocket costs, which could easily wipe out their entire nest egg and leave the female spouse, who may only be 70 or 75, with very little to live on besides Social Security, he explains.
“She could be left with nothing from the nest egg while still facing another 20 years or more of retirement,” Blanchett says. “So that’s another thing to point to. Planning for the loss of a spouse isn’t fun or easy, but it’s important.”