The basics of retirement planning are simple - based on how we want to live after retirement we can calculate how much we need to retire. If we know how much we need to retire, we know how much we need to save every month. Using our favourite financial calculators we can work out the right numbers down to the last cent - our retirement plan seems rock solid.
But retirement planning is an inexact science. We make assumptions about many important factors. We don't know how long we will live. If we leave early, we merely leave a larger inheritance for our loved ones. What happens if we live longer than we can afford to?
While we try our best to keep healthy, we cannot predict if we will always be in good health. Will we require medical treatment or even long term care after retirement? If so, how much will it cost, and will we be able to afford it?
Retirement planning involves making predictions about the future. This is a risky endeavour - in this article we'll look at three risks that can derail our retirement plan.
In 1980, average life expectancy in Singapore was around 72. 30 years later in 2010, average life expectancy rose to around 82. It is a possibility that 30 years from now, average life expectancy may rise to around 92 years.
Assuming we live until 92 and retire at 62, our retirement fund will have to provide us for 30 years. Using an average inflation rate of 2 per cent, and a monthly retirement income of S$2000, our retirement portfolio will need to reach a sizeable S$ 993 000.
Longevity risk exists as we do not know when we will die. Our assumption here is that 30 years in the future, average life expectancy will be 92 - this means that on average, half of us will die before 92, and half of us will live beyond 92.
If we live 10 years longer than our assumed average age of 92, our retirement need balloons to S$ 1.5 million. This is almost a 50 per cent increase from what we need to retire at 92. Not all of our expenses will be sipping martinis at sunset. At this age, it is likely that we spend more on medical treatment and long term care.
The longer we live, the larger the impact of healthcare costs on our retirement plan. One reason is that we are more likely to seek medical treatment as we age. Compared to younger individuals, the elderly use more health services, and stay in hospital for longer periods. The elderly are also more vulnerable to age-related ailments such as osteoporosis, cancer, and Alzheimer's disease.
Another reason why healthcare costs are significant to your retirement plan is that healthcare costs are rising quickly. In Singapore from 2005 to 2015, general prices increased by 22 per cent while healthcare costs increased by 31 per cent. A study by the Asia Pacific Risk Centre (APRC) predicts that average healthcare costs per elderly person (defined as someone at or above 65 years of age), at US$8 000 in 2015, will rise more than 4 times to US$37 000 in 2030.
Make sure your retirement plan is not derailed by accounting for healthcare costs. Healthcare costs are growing quickly, and as we age, healthcare costs form an increasing proportion of retirement expenses.
The best way to manage future healthcare costs is to be healthy. Healthcare expenses cannot be substituted easily - if we need a certain type of medical treatment or medicine, we can compromise on quality, or source for cheaper providers, but we cannot completely eliminate our need.
Market risk refers to the possibility of loss in your retirement fund from a financial market downturn. We invest our retirement fund in various asset classes to make sure that it grows over time, outpacing inflation. An asset class such as stock is risky but offers a higher potential return. An asset class such as a government bond is (usually) less risky, but offers a lower potential return.
If the market drops by 50 per cent, a $100 portfolio drops to $50. The portfolio needs to increase by 100 per cent to return to $100. Markets recover over time, but this can take years or even decades. Japanese stock markets have not recovered from their highs in the 90s.
A market downturn may not be a problem while you are still working and building your portfolio. You can work harder and make more money. Or you can be more frugal and increase your saving rate.
Market risk hits harder after retirement, when you are drawing a retirement income. This is because your withdrawal forms a larger proportion of your retirement portfolio during a downturn.
Imagine that a portfolio worth $100 halves to $50 during a market downturn. You withdraw $10 as retirement income leaving $40 in the portfolio. Luckily in the following year, the market rebounds by 50 per cent so your fund grows to $40 x 1.5 = $60.
Now imagine that you are still working. Your $100 portfolio is halved by a market downturn to $50. Luckily, the market rebounds by 50 per cent, and your portfolio recovers to $50 x 1.5 = $75.
After a market downturn, your portfolio recovers to $75, compared to $60 if you are drawing a retirement income. The point here is that during a market downturn, your retirement withdrawal further reduces your portfolio, limiting its ability to recover.
A one-off market downturn may not have a significant impact on your portfolio. But over the long course of your retirement, your portfolio will likely be buffeted by more than one market downturn. Each market downturn will reduce your retirement portfolio's ability to recover.