Common Factors Affecting Retirement Income

When it comes to planning for your retirement income, it's easy to overlook some of the factors that can affect how much you'll have available to spend. Retirement income can be impacted by investment risk, inflation risk, catastrophic illness or long-term care, and taxes. If you don't consider how these things can affect your income, you might not be able to enjoy the retirement you envision.

Investment risk

Different types of investments carry different risks. Understanding these risks--and how they can influence your available income in retirement--is essential for sound retirement planning.

"Investment risk" (or market risk) is the risk that fluctuations in the securities market may result in the reduction or depletion of the value of your retirement savings.

If you need to withdraw from your investments to supplement your retirement income, you'll need to determine how long your investments will last. In determining this, there are two important factors: the amount of withdrawals you take and the growth your investments experience.

You might presume that market fluctuations will average out over time. From that, you might estimate how long your savings will last based on an anticipated average rate of return. Unfortunately, the market doesn't always generate positive returns. Sometimes there are periods lasting for a few years or longer when the market provides negative returns. Prolonged periods of negative returns paired with constant withdrawals from your savings can result in your savings depleting far sooner than planned.

Reinvestment risk

Reinvestment is when you use proceeds earned from an investment to purchase more of that investment. This purchasing would be instead of receiving the earnings in cash.

"Reinvestment risk" is the risk that your proceeds available for reinvestment might have to be reinvested at an interest rate that's lower than the rate of the asset that generated those proceeds in the first place. This means that you might have to reinvest at a lower rate of return, or take on more risk to achieve the same rate of return.

This type of risk is often associated with fixed interest savings assets, such as bonds or bank certificates of deposit. When the asset matures, comparable assets may not be paying a return that is the same or better than the matured asset.

Interest rate risk

"Interest rate risk" is the risk that interest rates might rise and the prices of some existing investments might fall. For example, during periods of rising interest rates, newer bonds issued will likely yield a higher interest rate than older bonds issued during periods of lower interest rates. This would decrease the market value of the older bonds.

During periods of rising interest rates, you also might see the market value of some stocks and mutual funds drop. This is because some investors will shift their money from these stocks and mutual funds to lower-risk investments that pay higher interest rates compared to prior years.

Inflation risk

"Inflation risk" is the risk that the purchasing power of a dollar will decline over time, due to the rising cost of goods and services. If inflation runs at its historical long-term average of 3%, the purchasing power of a given sum of money will be cut in half in 23 years. If inflation jumps to 4%, the purchasing power of that money is halved in 18 years.

A simple example illustrates the impact of inflation on retirement income. Assuming a consistent annual inflation rate of 3%, and excluding taxes and investment returns in general, if $50,000 satisfies your retirement income needs this year, you'll need $51,500 of income next year to meet the same income needs. In 10 years, you'll need about $67,195 to equal the purchasing power of $50,000 this year. Therefore, to outpace inflation, you should try to have some strategy in place that allows your income stream to grow throughout retirement.

(The following hypothetical example is for illustrative purposes only and assumes a 3% annual rate of inflation without considering fees, expenses, and taxes. It does not reflect the performance of any particular investment.)

Equivalent Purchasing Power of $50,000 at 3% Inflation

Long-term care expenses

Long-term care may be necessary when physical or mental disabilities impair your capacity to perform everyday tasks. As life expectancies increase, so does the potential need for long-term care.

Paying for long-term care can have a significant impact on retirement income and savings, especially for the healthy spouse. While not everyone needs long-term care during their lives, failing to plan for the possibility can leave you or your spouse with little or no income or savings if such care is needed. Even if you decide to buy long-term care insurance, don't forget to factor the premium cost into your retirement income needs.

A complete statement of coverage--including exclusions, exceptions, and limitations-- is found only in the long term care policy. It should be noted that carriers have the discretion to raise their rates and remove their products from the marketplace

The costs of catastrophic care

As the number of employers providing retirement health-care benefits dwindles and the cost of medical care continues to spiral upward, planning for catastrophic healthcare cost in retirement is becoming more important. If you recently retired from a job that provided health insurance, you may not fully appreciate how much health care really costs.

Despite the availability of Medicare coverage, you'll likely have to pay for additional health-related expenses out-of-pocket. You may have to pay the rising premium costs of Medicare optional Part B coverage (which helps pay for outpatient services) and/or Part D prescription drug coverage. You may also want to buy supplemental Medigap insurance, which is used to pay Medicare deductibles and co-payments and to provide protection against catastrophic expenses that either exceed Medicare benefits or are not covered by Medicare at all. Otherwise, you may need to cover Medicare deductibles, co-payments, and other costs out-of-pocket.

Taxes

The effect of taxes on your retirement savings and income is often overlooked, but it is a significant aspect of retirement income planning. Taxes can eat into your income, significantly reducing the amount you have available to spend in retirement.

It's important to understand how your investments are taxed. Some income, like interest, is taxed at ordinary income tax rates. Other income, like long-term capital gains and qualifying dividends, currently benefit from special--generally lower--maximum tax rates. Some specific investments, such as certain municipal bonds,* generate income that is exempt from federal income tax altogether. You should understand how the income generated by your investments is taxed, so that you can factor the tax into your overall projection.

Taxes can impact your available retirement income, especially if a significant portion of your savings and/or income comes from tax-qualified accounts such as pensions, 401(k)s, and traditional IRAs, since most of the income of these accounts is subject to income taxes. Understanding the tax consequences of these investments is important when making retirement income projections.

Have you planned for these factors?

When planning for your retirement, consider these common factors that can affect your income and savings. While many of these same issues can affect your income during your working years, you may not notice their influence because you're not depending on your savings as a major source of income. However, investment risk, inflation, taxes, and health-related expenses can greatly affect your retirement income.

*Income from municipal bonds is not subject to federal income taxation; however, it may be subject to state and local taxes and, for certain investors, to the alternative minimum tax. Income from taxable municipal bonds is subject to federal income taxation, and it may be subject to state and local taxes.

Opinions expressed are those of the author and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.