An early retirement is a celebratory event when it happens according to your time line. But it can also be a financial wrecking ball when you’re forced to exit the workforce prematurely — something many Americans experienced during the COVID-19 pandemic.
Indeed, more than 3 million additional workers in the U.S. retired during the pandemic than is typical, according to a Federal Reserve Bank of Saint Louis analysis, which found “a significant number of people who had not planned to retire in 2020 may have retired anyway because of the dangers to their health or due to rising asset values that made retirement feasible."1
But it’s not just a global health crisis that can induce an early retirement. Injury and illness are among the most common reasons. Some on the cusp of retirement lose their jobs and choose to sit it out for good when their employer downsizes or their skill set becomes obsolete. And others stop working before they intended to care for an ailing loved one. (Learn more: Keeping caregiver costs contained)
“In most situations, retiring before you had planned could have enormous consequences to your retirement or require you to make significant changes to your retirement life, which may include having to downsize your home and minimize travel,” said Jane Schroeder, senior vice president of Lenox Advisors in Los Angeles, California. (Calculator: How much do I need to retire?)
Indeed, those who retire early need to consider the following potential financial risks:
Those who stop working before their normal retirement age are far more vulnerable to longevity risk — the likelihood of outliving their assets — because they must stretch their savings out over a greater number of years. They also have fewer working years to contribute to tax-deferred retirement accounts, so they start off with less in the bank.
“Longevity risk is one of the biggest threats to retirement,” said Schroeder. “More and more Americans are living half of their lives over the age 50. Inflation, market risk, long-term care needs are all factors that must be considered when planning for retirement. Longevity is a risk multiplier. It amplifies the amount of time that all other risks could impact their lives.”
A careful withdrawal strategy from their investment accounts as they convert their savings to income is essential, she said.
As a general rule of thumb, financial professionals often recommend a 3 percent or 4 percent withdrawal rate during the first year of retirement. Retirees can then adjust that amount higher annually to keep pace with inflation. (Learn more: The ideal retirement withdrawal rate)
Assuming their investment portfolio earns more than 4 percent on average per year, that withdrawal rate ensures that they will only ever spend their earnings and leave their principal untouched. Inan ideal world that should eliminate the risk of depleting their savings for at least 30 years. But your withdrawal rate may be higher or lower depending on your unique financial picture.
Early retirees, who need their savings to last longer, may need to learn to live on less. They may also need to reduce their expenses by downsizing to a cheaper house or simply return to work (even part time) for a few extra years to bolster their retirement nest egg.
Those who have the means can also potentially delay claiming Social Security benefits a few extra years to permanently increase the size of their future Social Security checks — the best way to give yourself a raise during retirement. (Learn more: 4 simple ways to delay Social Security)
Another way to potentially ensure that you have sufficient funds for life is to purchase an annuity, which can provide guaranteed lifetime income. Annuities are a type of insurance contract that can be funded through personal savings or a rollover of retirement funds. But different annuities offer different types of advantages and drawbacks. Ask your financial professional for guidance. (Need a financial professional? Find one here)
Health insurance coverage
Many early retirees underestimate the potential cost of paying for private health insurance during the years before they become eligible for Medicare, the federal health insurance program covering those age 65 and older, certain younger people with disabilities, and those with end-stage renal disease.
Premiums for private health insurance, even for a few years, can consume an oversized portion of your savings, which could undermine your ability to make ends meet throughout retirement.
Options for coverage include COBRA, a spouse’s insurance, retiree health insurance benefits, the public marketplace, private health insurance, membership-based group health plans, and Medicaid for those with demonstrated financial need. (Learn more: Retiring early? A guide for securing health insurance)
Long-term care (LTC) coverage, which picks up where Medicare leaves off, can potentially curb future costs related to assisted living and nursing home care. Some hybrid life insurance policies include LTC coverage.
According to Genworth, the monthly median cost of a home health aide is about $5,100, while assisted living facilities cost $4,500, and a semiprivate room at a nursing home facility can cost more than $7,900.2
“Long-term care is a huge risk that I believe gets very overlooked,” said Armando Sallavanti, a financial professional with MassMutual Greater Philadelphia, referencing federal government data, which estimates roughly 60 percent of U.S. adults will need help with things like getting dressed, driving to appointments, or making meals at some point in their lives. “This can completely deplete someone’s retirement savings alone. The longer we live, the more likely we will need long-term care.”
But long-term care coverage is not ideal for everyone. It is generally not recommended for those with minimal assets who are likely to qualify for Medicaid, the federal-state health insurance program for low income and disabled Americans. Similarly, those with health issues or a family history of chronic illness may find that LTC coverage is cost prohibitive or even unavailable.
Before buying an LTC policy, Sallavanti recommends retirees speak with a financial professional to determine whether such coverage is the right fit for their family.
The rising cost of goods and services, otherwise known as inflation, is enemy number one for retirees.
When you no longer produce an income, any increase in consumer prices erodes your purchasing power. And the more years you spend in retirement, the bigger that threat becomes.
Historically speaking, inflation rises from 1 percent to 3 percent per year. Doesn’t sound like much? Think again. Assuming a 3 percent annual inflation rate, a 55-year-old making $50,000 per year who retires today would need the equivalent of about $91,000 by age 85 to maintain the same standard of living, according to the CalcXML inflation impact calculator.
Inflation, of course, doesn’t always remain within the federal government’s target range. In early 2022, the Consumer Price Index soared to 7.5 percent, the biggest spike in consumer prices since 1982. (Learn more: What should investors do about inflation?)
“Inflation has been a hot topic recently,” said Sallavanti. “The issue in retirement becomes maintaining a safe-enough portfolio to distribute income from while creating enough returns in the portfolio to out-pace inflation to maintain your standard of living. Off of this, many retirees may need to factor in ‘raises’ to their income throughout retirement.”
Retirees typically scale back their level of investment risk because they depend on their retirement savings for income and can’t afford a period of prolonged losses. While that may be age appropriate, it is also a risk to become too conservative with their asset allocation. Most will need to keep a portion of their portfolio invested in equities for growth to outpace inflation.
“This is just like being on the 5-yard line in a football game,” he said. “The yards that came before this are far less important than the five yards in front of you. A mistake here could ruin every good move before this. Once we get to that ‘red zone,’ it is imperative we still accumulate some growth, but have a preservation/income protection strategy in place to avoid a 'turnover' or detrimental mistake.”
Sequence of returns risk
New retirees, regardless of when they leave the workforce, must also be mindful of market performance.
Those who retire into a bear market, or experience losses or low returns in the early years of their retirement, are statistically far more likely to outlive their savings than retirees who experience losses later on. (Learn more: Beware retirement’s overlooked risk: Sequence of returns)
To safeguard their financial security, Sallavanti recommends retirees use both an offensive and defensive approach to saving and investing.
“The offense is their growth portfolio, which will be the investments where they accumulate wealth,” he said. “The defense is what will give them protection against sequence of returns risk because it has a component that is uncorrelated to the stock market. It is where they can pull income from when the market is down, rather than selling their investments at a loss.”
Indeed, while permanent life insurance policies are primarily designed to provide a death benefit to protect the ones you love, they also build cash value as premiums get paid – and you can borrow from your cash value for any purpose.
For example, retirees can use their cash value to pay the bills when the market is down, giving their investment portfolio time to recover, said Sallavanti, adding that simply having that cash cushion on hand often enables his clients to take a withdrawal rate from their investment portfolio that is higher than the typical 3 percent or 4 percent per year. (Related: How whole life insurance helps in retirement)
“This defense strategy has a death benefit for their heirs if they die too soon and some may include long-term care coverage, too,” he said. “We typically use life insurance-based products to build this defense because it allows clients to maintain a growth focus in their offense, knowing with certainty that their defense will be there for them during market losses.”
Keep in mind that borrowing from your life insurance cash value increases the chances that the policy will lapse, reduces the cash value and death benefit for your heirs, and may result in a tax bill if the policy terminates before the death of the insured.
Another way to offset sequence of returns risk is to create a traditional emergency fund worth at least 12 months of living expenses in a liquid account, such as a savings or money market account, from which retirees can draw an income during periods of market downturns.
It’s one thing to plan for an early retirement, but quite another to be forced out of the workforce prematurely. With careful planning, professional guidance, and tools to mitigate multiple risk factors, however, it may still be possible for early retirees to live the lifestyle they had envisioned.
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