Summer is over and the kids are back in school. Although we’re just getting into the rhythm of the new school year, I’m already thinking about winter break (and a potential family vacation). Although it’s hard to plan for winter when I’m still wearing short sleeves, I know it’s just around the corner … similar to retirement.
Whether you’re planning for a future vacation or retirement, it’s tempting to focus only on the positives. But you also have to contend with the unknowns, such as bad weather or unexpected expenses. In either case, it’s best to be as prepared as possible.
Defining “financial security”
So what does it mean to be financially prepared for retirement? Is it simply having a certain level of assets or stream of income, or is it something a bit more abstract like having “financial security”?
Before you can answer this question, you need to consider your financial goals. Many people have a pretty good handle on what it takes to cover their basic living expenses. But it’s important to remember that complexities can arise: How much should you set aside for health care expenses or emergencies? How can you enjoy retirement but still leave something for family members or charity? Those are big questions with few concrete answers.
To help balance the many decisions you’ll need to make, we recommend taking a 3-step approach:
- Set and prioritize retirement goals.
- Evaluate the risks that may jeopardize these goals.
- Select the financial resources that may help achieve your goals and mitigate the potential risks.
Following this framework (more to come in an upcoming research paper) can help you identify your priorities, understand the various trade-offs you may have to make in order to reach your goals and, finally, help you make the best possible use of your financial resources.
Step 1: Set and prioritize goals
While a good vacation destination provides many fun and interesting things to do, you usually don’t have time to enjoy everything. That’s why it pays to prioritize—differentiating the “must dos” from the “nice to dos.” Retirement planning is no different. Understanding the hierarchy of your retirement goals can help ensure that you’re on track to achieve your highest-priority goals before dedicating resources to those lower on the totem pole.
Having a multigoal framework allows you to focus on the relative importance of your goals―paying for housing versus going on vacation, for example―while incorporating your preferences, such as leaving a legacy.
Retirement goals tend to fall into 4 broad categories:
- Basic living expenses (food, clothing, recurring health care expenses).
- Contingency reserves (home repairs, unanticipated health care expenses).
- Discretionary spending (vacations, dining out, leisure activities).
- Legacy (bequests and charity).
It’s important to differentiate your wants from your needs and allocate your resources to cover your most vital expenses first. But keep in mind that it may not be possible to achieve all of your “nice to dos”; you may have to give up some of your lower-priority retirement goals.
Step 2: Evaluate the risks
Once your retirement goals have been clearly defined, you need to understand the risks that could jeopardize them. Here are some to consider:
- Market risk: the risk that market returns will negatively impact your portfolio balance.
- Health risk: the risk that your health will decline and cause a significant financial burden.
- Longevity risk: the risk that you’ll outlive your resources.
- Event risk: the risk that an unexpected event will have a large financial consequence.
- Tax and policy risk: the risk that tax and government policy changes will result in additional spending from your portfolio.
It’s important to understand your sensitivity to each risk. For example, if your portfolio is aggressively invested in stocks, you’re exposed to more market risk than an investor who invests heavily in bonds. However, a bond-heavy portfolio might increase your longevity risk.
Once you’ve determined your risk tolerance, consider the implications. How will your resources support you if you’re faced with a worst-case scenario?
Step 3: Allocate financial resources
Your retirement resources include your assets (stocks, bonds, cash, etc.), your income sources (salary, pension, rental income, trust income, etc.), and the products you own (annuities, health insurance, life insurance, etc.).
Your retirement resources can be grouped into 1 of 3 categories:
- Guaranteed income: income you can count on, such as pensions, Social Security, or income annuities.
- Liquid investments: financial assets that can fluctuate in price, such as stock and bond funds or other savings.
- Additional resources: nontraditional sources of income, such as rental or part-time income, and other products or property that have value, like real estate and insurance coverage.
In many cases, using one resource to mitigate a risk may actually increase a different risk. For example, purchasing an annuity increases your guaranteed income but decreases your liquid investments, which can help pay for unexpected expenses in the near term.
A sound retirement plan balances the benefits and trade-offs of your lifestyle choices while staying focused on achieving your highest-priority goals. When you apply this framework, you may find that you’re comfortable spending less early in retirement so you can afford premier in-home health care for extended time later in retirement. Or you may decide that you want the flexibility to pay for traveling earlier in retirement knowing that you’ll be able to afford basic health care later in retirement.
Start preparing today
When my family goes on a vacation to the beach, we pack board games, books, and movies to keep us busy if it rains. The same type of preparation can help you face what’s ahead in retirement: Prioritize your goals, evaluate risks, and understand the resources you have at your disposal.
Each person’s circumstances, resources, and concept of financial security are different, so it’s important to customize your retirement plan to suit your situation. To me, being prepared for retirement means that throughout my life I’ll be able to pay for all of my financial goals—including educating my daughters, traveling abroad, owning a second home, and leaving a modest legacy. Too ambitious? Maybe. But it’s a starting point.
What does being prepared for retirement mean to you?
All investing is subject to risk, including the possible loss of the money you invest.