4 Early Retirement Risks – and How to Avoid Them
August 31, 2012
In the last few years early retirement has become the holy grail of retirement planning. After all, if retirement is a good thing, then early retirement is even better!
The abundance of investment vehicles like the IRA and 401k combined with easier and wider access to investment information, in tandem with the power of compound investment income has even made early retirement more doable than ever before.
But with all of its positives, early retirement is not without some risks. Here are at least four that I’ve been able to identify.
Out-living your money
With people now routinely living into their 80s and even 90s, there is a real risk of out-living your money even if you retire at age 65. Taking early retirement at 50 or 55 only increases that risk. By retiring at 50, you may need your investments to cover 30, 40—even 50 years. That’s a tall order even in the best of circumstances.
How do you avoid out-living your money when you retire?
1) Build a bigger investment portfolio than you think you’ll need. One of the best ways to insure against out-living your money is to have more of it than you’ll need. If you think you’ll need $1 million to retire at 50, plan on having $1.5 million or even $2 million. Then plan to draw income from the $1 million you think you’ll need, and pretend the extra money doesn’t even exist.
2) Start saving and investing early. If you’re going to live 30 or 40 years in retirement, you’ll probably need at least that much time to prepare for it. And the normal 10-15% of income that many people consider to be adequate for retirement savings probably won’t cut it. 20-25%, or even 30% or more is more like it.
3) Plan to live beneath your means in retirement. If you’ve been saving an outsized percentage of your income in order to prepare for early retirement, you’ll already be ahead of the game. But when you retire, plan to cut your standard of living even more, run the numbers in a retirement calculator to see how much you’ll really need to live on. This will be especially important during the first years of retirement. You don’t want to be drawing down your investments too early.
4) Don’t ignore inflation. Inflation is the silent enemy of retirement. It’s been tame for the past few years, but don’t rule out a return. This is especially important when you retire early. The investment portfolio that provides so well for you at 50 can drop substantially in value by the time you hit 65 or 70. Getting a return on your investments that supports your lifestyle won’t be sufficient. You’ll have to cover lifestyle and inflation. That means you’ll have to continue to invest at least a portion of your retirement portfolio in growth type investments throughout most of your retirement.
Relying exclusively on retirement assets
One of the things you don’t want to do very early into your retirement is rely entirely on your investments to provide your living. (Of course, if your retirement stash is well into the millions, feel free to disregard this advice!) Since you will need your retirement investments to cover not years, but decades, you’ll have to have a strategy in place what will extend your portfolio to cover the rest of your life.
There are two problems that could happen if you try to rely entirely on your investments:
- You could be draining assets that you’ll need later in life, as in really need later, and
- You might use up investment assets in a bear market that may be needed to recover lost ground when the market turns up (more on this one in the next section).
The “safe withdrawal rate” on retirement assets is generally considered to be 4% of your portfolio, but I wouldn’t test this theory too heavily—at least not in the early years. You might want to have other income sources that will help provide for you through the time of your retirement up until you reach 65 or 70. Those sources could be passive income streams, proceeds from the sale of property or even some kind of part-time employment like freelancing or consulting work (more on that too).
Once again, you’ll be providing for yourself for decades and anything you can do that will reduce the drain on your investments early on will pay for itself later.
An untimely bear market or even a crash
Bear markets and crashes are bad enough when you’re in your working years and saving up for retirement. But if one hits when you’re retired it could force you to change your plans. A 40% or 50% slide shortly after retiring could even take you out of retirement.
What do you do to prevent this from happening?
- You may have kept 80, 90 or even 100% of your investment capital in stocks while you were working, but once you retire you’ll have to move a big chunk of it into more conservative assets—the type that aren’t likely to tank with the market. They’ll limit your gains in bull markets, but they’ll lower your losses in bear markets and when you’re retired that’s a good trade off.
- Have a pile of non-retirement savings that you can tap for living expenses during bear markets; this will allow you to keep your capital intact to invest for eventual recovery rather than using it to pay bills.
Letting your career skills slip
Just because you’ll be retired doesn’t mean you should become irrelevant from an employment standpoint. We’re discussing the risks of early retirement and it’s pretty clear that the best way to prepare for those risks is by having alternate sources of income. Your career skills should be one of those sources.
We touched on this a bit earlier, but keep some sort of connection with your pre-retirement career so that you can do freelance or consulting work if you need to in a pinch. You can also develop new skills or consider starting some sort of part-time business. The purpose isn’t to get so deep into working that you’re not truly retired, but rather to have a Plan B just in case you have to.
And this is just a guess, but if you retire at 50 or shortly there after, it’s very unlikely that you’ll become completely idle. At that age you’re far too young and still have too much to offer, and you’ll probably want to do something that looks a lot like gainful employment.
The point isn’t to compromise your retirement, but to be ready to do what ever you need to to sustain it over the decades to come.
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