Saving and investing for retirement boils down to one fundamental job: Identifying the financial risks to your retirement plans, and defending yourself against them.
“We are more responsible for managing our own retirement than we have been in the past, so it’s critical we consider the risks we face,” says Michael Finke, a professor of personal financial planning at Texas Tech University.
Consider the following financial risks—and take steps to minimize their effects:
1. Market risk
Perhaps the most familiar risk investors face, market risk is the possibility that your savings will lose value because of declines in the financial markets. Stocks are particularly susceptible to market risk in the short term. However, stocks’ risk decreases the longer they are held: They’ve produced gains during every period of 20 years or longer since 1926.1 And historically stocks have offered the greatest growth potential of any asset class. Bonds and cash investments offer greater stability but much less growth.
The longer you have until you’ll draw on your savings, the more market risk you can afford to take in pursuit of growth. So if you have a decade or more until retirement, you might hold all but a small portion of your portfolio in stocks. As you approach retirement you can convert some of your stock holdings to bonds and cash to protect what you’ve accumulated.
2. Inflation risk
Rising prices gradually eat away at your savings’ purchasing power. Consumer prices increased by about 2 percent in 2012; historically inflation has averaged about 3 percent a year since 1926.2 “If you haven’t invested in assets that rise with inflation, the money you’ve saved for retirement will buy less over time,” says Finke.
You can combat inflation risk by holding some growth-oriented investments, such as stocks, into retirement. “Retirees should consider accepting some market risk to make sure they have a better chance at beating inflation,” says Finke.
You also might consider investing in products such as Treasury Inflation-Protected Securities (TIPS), which offer inflation-adjusted payments. Social Security, which provides a lifelong income stream, also is adjusted for inflation.
Life expectancy is on the rise: Today the average 65-year-old man is expected to live to age 84, while the average woman that age is likely to live to 86.3 Longer life spans increase longevity risk, the possibility that you may outlive your savings.
A diversified portfolio that includes exposure to stocks’ growth potential can help safeguard your income throughout your life. Longevity insurance also may help. These policies offer payments that begin after you’ve reached advanced age.
The risks you face are real, and it’s impossible to avoid them altogether. But if you understand the risks, you can manage them—so you can live the retirement you envision. A financial advisor can help you create a plan based on your particular situation.