Retirement security is a holy grail that many investors chase. A recent AARP survey revealed that 74 percent of private sector workers are anxious about having enough money to live comfortably in retirement.
Although increasing savings may seem like the answer, creating a sustainable retirement strategy is a bit more complex. Investors must also plan for costs that can detract from their portfolio's growth. "Taxes, long-term care and inflation all have the potential to eat away at your retirement savings," says Marcy Keckler, vice president of financial advice strategy at Ameriprise Financial in the greater Minneapolis-St. Paul area. "Not planning properly could result in a substantial blow to your portfolio from a sudden need for extended care, or inflation could slowly chip away at your nest egg."
Health care may be the biggest threat. Long-term care poses two problems for retirees. First, the cost can be staggering. Genworth Financial puts the average annual cost of nursing care in a semi-private room at $85,775. Assuming a typical two-and-a-half-year stay, the total bill for end-of-life care easily surpasses $200,000. The second issue is that these expenses don't fall under the Medicare coverage umbrella. Medicaid will pay for long-term care but requires seniors to spend down their assets to qualify.
Long-term care has the potential to be the most devastating to an investor's retirement strategy, says Steven Yager, a financial advisor with Yager & Associates in Northville, Michigan. The root problem is longevity. "People often assume that since their parents or grandparents lived to a certain age, they'll live to a similar age. They then base their retirement plan on this uneducated assumption about their own life expectancy."
Health care can encroach on your retirement security when expectations don't match reality. There are two possible solutions: Self-fund these expenses or invest in long-term care insurance. Self-funding may require you to increase your current savings rate or rethink your overall strategy. For example, you may need to maintain a larger share of stocks to generate growth in your investments for a longer period if you're trying to fill a long-term care funding gap.
Long-term care insurance can cover health care costs while leaving your portfolio intact, but because of their high premiums, these policies may suit some investors better than others. "It comes down to your asset base," says Jason Laux, vice president of Synergy Group in White Oak, Pennsylvania. "For people without a lot of assets, long-term care insurance usually isn't appropriate. For those who are wealthy, it may make more sense to be growing and investing your money."
Investors in the middle, with assets ranging from $350,000 to $1 million, could benefit most from a long-term care policy. Although these investors may not have enough wealth to self-fund, they can afford the higher premiums to avoid the Medicaid spend-down requirement.
Protection from higher prices comes at a cost. Inflation can be detrimental to retirement savings. Research from insurance consultancy LIMRA suggests that a retirement portfolio could lose more than $73,000 in purchasing power from a 2 percent inflation rate. The effects of inflation may be compounded when increases in certain expenses – such as health care – outpace rising prices in general.
Including inflation-hedging investments in your retirement plan offers a measure of protection for your portfolio. Annuities and Treasury inflation-protected securities are two options for taming inflation's effects.
Annuities are designed to provide tax-deferred growth and generate a guaranteed stream of income, which can supplement income from tax-advantaged retirement accounts, taxable investments or Social Security benefits. With TIPS, the principal value of the investment adjusts up or down in tandem with changes in the consumer price index. These investments yield lower returns compared to stocks, but they can be useful by shielding investors against the negative effects of inflation.
While both annuities and TIPS can benefit investors in retirement, there are some downsides to consider, says Joy Kenefick, managing director of investments with Wells Fargo Advisors in Charlotte, North Carolina. Annuities can offer guaranteed income or guaranteed protection in volatile or declining markets, but the expenses, complexity and lack of liquidity may make them a less than perfect fit for your investment needs.
TIPs, by comparison, offer modest returns in exchange for protection against market volatility and inflation. The benefit they offer comes at the cost of performance and growth, Kenefick says. Before buying into either one, assess the value and purpose of these investments for your retirement strategy.
Diversification should address this overlooked risk. Many investors diversify their assets for risk but not for taxes, Laux says. "They funnel the majority of their investments into pre-tax accounts and are told they'll be in a lower tax bracket when they retire but often don't find that to be true." Without tax diversification, he says, you could end up paying the maximum taxes on all your retirement assets.
Creating tax diversification begins with knowing what you've invested in and where those investments are held. Tax-inefficient investments, such as bonds, belong in tax-deferred accounts, while tax-efficient vehicles, like stock index funds, should be held in taxable accounts. Growth stocks can be used in a 401(k) or similar account to capitalize on the compounding benefit of tax deferral, says Melinda Kibler, a certified financial planner with Palisades Hudson Financial Group in Fort Lauderdale, Florida.
Minimizing the tax bite on your investments becomes even more important when you begin withdrawing money from those accounts. "The way in which an investor harvests from their portfolio is more consequential than the way one saves," Kenefick says. Investors should tap non-qualified accounts first, she says, leaving tax-sheltered accounts to compound and avoid "the eroding effects of paying taxes for as long as possible."
Calculating your target withdrawal rate accurately also matters. Daniel Prince, head of product consulting for BlackRock's iShares U.S. wealth advisory business, says an optimal withdrawal strategy requires retirees to be accurate on both sides of the ledger. Retirees should be realistic about their income and assets, and balance that against their spending. "Taxes will always be a cost," Prince says, but between long-term care and inflation, it's the easiest of the three to proactively reduce.
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