Posted by Tim Stobbs on April 25, 2016
Perhaps one of the more confusing things out there for people planning their retirement is what to do about risk. What happens when you live longer than you planned? What if you kids needs help paying for a wedding? What if your investments have a lower return than expected? What if inflation is higher than you planned? The potential problems are basically endless if you want to keep thinking about it.
As a result most people tend to be conservative when they start their planning for retirement trying to account for those risks. They include a lower than expected investment return, inflated spending estimates and even high inflation values. Yet this line of thinking can get out of control and people end up leaving the world of risk management behind and try to eliminate all the risks. Why? Because they are frighten that something will go wrong.
Yet that really isn’t a healthy approach to the problem. The main issue is life never goes according to plan. Think about your last weekend, did everything happen just the way you wanted it to? Likely not, now take that problem and magnify it over 40 years or more. Ah, you likely see the full scope of the problem now. Focusing on eliminating all risks creates a situation where your odds of retiring earlier keep dropping as you work longer trying to cover every remote possible thing that could go wrong in your retirement plan. You are so focused on the next risk, you end up over saving for your retirement and thus have now increased another risk of not getting enough time to enjoy your own retirement.
On the other hand, I’m not suggesting you go in with nothing done about risk, that would also be foolhardy. Instead I suggest you shift gears from removing or eliminating risk to just managing it. When you manage risk you do try to be defensive on some items and account for them in your planning. While others may in fact be too remote of a possibility or too minor of a problem to bother managing at all. In those cases, you accept the risk and do nothing. This might seem odd, but in fact in business this happens all the time. For example, you can accept a contract with the default wording for a small purchase and accept that if something goes wrong you will just deal with the issue and perhaps be out some money.
For example here are a few items in my retirement plan and what we are doing about managing the risk:
- The End of the World – Frankly if that happens my plan likely won’t matter so I’m just going to accept that risk and not even bother trying to plan for it. If society ends, you likely have other issues to worry about – like getting food rather than tax issues with RRSP withdrawals.
- The End of the Stock Market (aka 80% decline in stock values) – The odds on this occuring for EVERY stock is beyond remote and similar to the above. So again, I’ll accept the risk on this one.
- The Stock Market declines 10 to 20% – Alright, this is a reasonable possibility in a given year. So the plan here would be to cut back on spending where possible, keep of float of cash for a year’s worth of expenses to avoid selling in a major downturn and if need be I can do some part time work to cushion the blow to our finances even further.
- My spouse dies early and I no longer receive their Old Age Security (or vice versa) – Again, with an accident this is possible, which is why I only included 50% of our total estimated Old Age Security payment in our plan. That way if things go well we have some extra money, if not, this won’t put us in the poor house either.
- Our car breaks down and needs to be replaced, the house roof is damaged in a storm and the fridge dies (all in the same year) – While individually these aren’t a big deal in a given year the compounding effect of having all of these at once may drain the extra cash to very low levels. So a few options exist like using a line of credit to borrow some of the money to spread the payments out over a few years. Yes this costs some interest, but it allows us to keep some cash reserves in case something else occurred. Also there is insurance to cover the car and the house if the event true accidents occur for the cost of the deductible.
- We need major dental work after retirement – In theory I could get some insurance to smooth this cost out or have the option to just self insure (ie: don’t pay any premiums and accept the risk). In our case, we have fairly good teeth overall and I don’t see much risk here. So I’m going to just ignore this one and self insure.
The idea of course is to put your mind at ease by going through some of the more obvious problems and determined ideas in advance on how to solve them. Then of course you can also accept the odds on the more exotic situations and do nothing. Just keep a few management tools in your back pocket like: one year of spending saved in cash, appropriate insurance coverage, the option of picking up some part-time work when you are younger, selling stuff you don’t use anymore, the potential solutions are like the problems: endless. Just make sure you have several of them ready to go in case you need a few.