7 Steps to Creating a Risk-Free Retirement Plan
When it comes to saving for retirement, setting goals can be difficult. Just how much should you save? How should you invest those savings? When should you start drawing down on your retirement savings? And just how long will that money last?
The last of these questions is, perhaps, the most important. When we talk about planning for retirement, we are really talking about mitigating risk. The more money you save, of course, the less likely it is that you’ll run out of money.
Unfortunately, it’s not possible to create an entirely risk-free life. Just like it’s not possible to plan a completely risk-free car ride to the grocery store. Life just comes with risks. With that said, it is possible to mitigate risk in retirement so that you can live relatively worry-free–at least when it comes to your money.
Here are 6 steps to help you lower your retirement risks so that you can relax and enjoy your golden years.
1. Set Two Goals for Your Risk-Free Retirement Plan
When we talk about setting goals for retirement, we often talk as if we’re just setting one goal. This is the nest-egg amount you plan to have saved before you retire. Or it’s the percentage of your income you plan to save every year until you retire.
But this misses an important element of personal finance: the ability to adapt.
If you have less money during retirement, to a point, you can get by. You’ll figure out where to move, how to save, or how to keep side hustling so that you have enough to keep soul and body together. Sure, it might be more comfortable to get 80% of your pre-retirement income each year, But could you actually live on 60%?
As you’re setting retirement goals, set two. One is your must-have goal. This is the amount of money you’ll need each year to meet your basic needs. Then you can set your reach goal. This is what you’d like to draw down each year so that you can really enjoy your retirement.
The lower-end goal isn’t your dream retirement. And if you work at it, you can likely come out ahead of that goal. But that first goal is the one you fund first. And you can invest in a particular way to ensure that minimum standard of living.
2. Invest a Portion in TIPS
So how much do you need to meet those most basic needs? Once you’ve calculated that, run some calculations for how much you’d need to invest in TIPS–Treasury Inflation Protected Securities–to meet just that goal. Sure, TIPS aren’t going to earn you any fabulous interest. But they’ll beat inflation and they’re as risk-free as it gets.
It can still be difficult to run these calculations. How many years do you need to meet this minimum standard? How much can you expect to earn over a long time with TIPS? This retirement calculator might be helpful in figuring out the answers to these questions.
The bottom line, though, is that you can save a lot of money in TIPS, and that money is virtually guaranteed to stay safe, regardless of what the market or inflation does. If you want a risk-free retirement, funding it in this way lays the foundation for that to happen.
3. Invest the Rest in Riskier Options
What should you do when you reach your TIPS investment goal? Once you’re there, you can invest the rest of your money in riskier options. How much you risk will depend on your personal risk tolerance. If you want to take a real chance–knowing you have your retirement basics covered–you can invest the money in some wild startup that could go boom or go bust. Or you can take a more conservative approach by investing in a balanced stock market portfolio.
Either way, taking on more risk is more likely to come with some rewards. And if you invest conservatively in the stock market, you’re less likely to lose it all. And you may just come out well ahead of the game with plenty of money to ramp up your retirement lifestyle.
4. Retire at the Right Time and the Right Way
If you can retire when your assets are at a peak, that’s a good option. But the problem is that you never know when that peak is going to turn into a valley. So keep an eye on the market and your portfolio, and do your best to retire at the right time.
With that said, you may also want to consider an alternative like partial retirement. Working part-time on the side can help you have more leisure time to enjoy while leaving more of your assets in place to continue growing. Each year you continue working, even if it’s only a few hours per week, mitigates the risk of running out of money in retirement even more.
5. Save, Save, Save
The biggest problem with this plan is that it requires a lot of money in savings. To invest enough in TIPS to fund 15 years or more of retirement–that’s a good chunk of change. So if this is the type of risk-free retirement you want, you’ll need to ramp up the retirement advice the experts give for the “normal” retirement plan.
Most expert advice is predicated on the fact that you’ll retire around 65 having invested most of your money well in a combination of investments yielding around 6% to 8%. If you want to invest in TIPS instead because of their level of security, you’ll have to save a lot more.
So you’ll want to start saving for retirement in your 20s, if at all possible, or get started in your 30s if you’re still paying off student debt. Save as much as you can, but also focus on getting and staying debt free and building an emergency fund.
In your 40s, you’ll need to sock back well over 10% of your income. Some estimate that with a lower-interest investment plan, you’ll need to save upwards of a third of your income in your 40s. During this time, you’ll also want to make sure you’re debt-free and that you’re dealing with healthcare expenses and planning for how to cover your healthcare as you age.
In your 50s, you’ll still need to be saving as much as you can, and working to maintain your retirement. If you decide to invest in the market earlier in your investing life, you might start to pull back those investments into safer options like TIPS at this point.
6. Know Your Limits
Truly risk-free or very low-risk retirement plans are easiest for the super-wealthy to achieve. When you have several million dollars saved, you could invest it all in TIPS and live off of a tiny percentage of your total assets. But if you’re in the middle class, saving the amount of money you’d need to have this plan could be out of the question.
With that said, it’s a good idea to think through what a risk-free retirement would look like for you. This type of planning can give you insight into ways that you can mitigate risk while still following more conventional investment advice and investing in a mixed portfolio.
As with everything else in life, retirement will almost never be completely risk free. But that doesn’t mean you can’t make choices that help reduce your overall retirement risks so that you can rest easier during your retirement years.
7. Use Planning Tools
There is a wide variety of online and offline retirement planning tools that will get all your retirement funds together. We have tried most of them and found them good and helpful. Though we have to note one of those tools as our favorite – Empower Retirement Tools. Empower features sophisticated, yet simple and intuitive tools that will assist you in building a retirement plan (even a risk-free retirement plan). Read our extensive Empower review and find out all about this terrific tool that can enhance your retirement planning.
(Personal Capital is now Empower)
I have read your book more than once and found it very informative and out of the box thinking. While no one can be sure what style of investing is the best, yours does seem very safe orientated with a high value put on extra saving. Here are a few of my concerns regarding TIPS. First of all I believe the CPI completely understates inflation. I think that is very obvious especially in this ecomomy. 2nd, since TIPS have only been around since 1997 they have never been tested in a hyper-inflation type of enviorment which I believe is a strong possiblity in the near future. 3rd, with the massive printing of money (QE 2 and who knows how many more) and the massive debt this country has, isn’t a treasury default a very real and maybe near possibility? Will TIPS survive in these type of enviorments?
The risk of a TIPS investor is less than that of a muni bond investor and a stock investor only if you buy into the idea that it is impossible for the US government to default on its obligations. Many are unaware that US has in fact declared bankruptcy in the past – twice. Based on the amount of the off the books debt currently carried by our nation, and the recently enacted new trillion dollar entitlement program, doubt continues to grow about our nation’s ability to fulfill its obligations. A bet on TIPS is a bet on the continued solvency of the US government. Caveat emptor – let the buyer beware.
I just came across this column by Stuart Fowler in the FTFM section:
Avoiding risk is not the way to make money
By Stuart Fowler
Published: February 14 2010 10:30 | Last updated: February 14 2010 10:30
Here is my response:
In his column, Mr. Fowler has misinterpreted my recommended approach to personal investing. In our book, Worry Free Investing, Ian Sykes and I advocate safetyFIRST, not safety ONLY. We begin the investment advisory process by defining a minimum future level of income or wealth that the client wants to attain for sure. That determines a certain minimum amount that must be invested in inflation-linked bonds each period. (It is a function of the real rate of interest on these bonds.) If the client is willing to save and invest more than the minimum required to achieve her “floor”, then the additional amount can be invested in equities or other risky assets in the hope of achieving a higher level of future income or wealth.
Ironically, this appears to be very similar to the process that Mr. Fowler follows in his investment advisory business. Perhaps he and I are in violent agreement. I reproduce below the summary of the 6 step process in our book:
Six Steps to Worry-Free Investing
The essence of this book’s worry-free investment approach can besummed up in the following six-step process:
1. Set goals. Make a list of the specific goals you want toachieve through your saving and investment plan. For example, “I want to continue to live at my customary standard of living after I retire,” or “I want to pay for my children’s college tuition at Harvard.”
2. Specify targets. Determine the amount of money you will need to achieve each goal. These amounts become the targets of your plan. The very definition of risky or safe investing will depend on the target. TIPS and I Bonds have substantially lowered risk if the goal is retirement, but for college saving, special tuition-linked accounts are safer.
3. Compute your required no-risk saving rate. Figure out how much you need to save as a fraction of your earnings on the assumption that you take no investment risk. For many people, it is appropriate to count your house as a retirement asset
4. Determine your tolerance for risk. Using as yourbenchmark the lowered-risk plan you have created in Steps 1–3, evaluate how much risk you are willing to take. Your capacity to tolerate investment risk should be related to the riskiness of your projected future earnings and your ability and willingness to postpone retirement if necessary. The safer your job and your future earnings, the greater your tolerance for risk in your investments. The more willing you are to postpone retirement if your risky investments perform badly, the greater your tolerance for risk.
5. Choose your risky asset portfolio. After deciding how much of your wealth you are willing to put at risk, choose a form for taking the risk that gives you the greatest expected gain in welfare.
6. Minimize taxes and transaction costs. Make surethat you are not paying any more in taxes, fees, or otherinvestment costs than is necessary.
Chapter 7 of Worry Free Investing is entitled Taking calculated risks in the stock market. It explains and elaborates on step 4 above. One of the ways we explain to get maximum potential gains while still maintaining the minimum floor is to invest a small part of one’s portfolio in equity index call options. We have been called reckless for even suggesting this possibility. But our view is that the stronger your safety net, the higher you can aim your trapeze.
If Mr. Fowler interprets the book to mean that we advocate taking no equity risk exposure, then we were not clear enough in our explanation.
In any event, I hope that he avoids the fallacy of thinking that equities become safer in the long run, and that he makes it clear to his clients that equities are very risky even in the long run. Unfortunately, many investment advisors try to persuade their clients that you can get the equity risk premium without taking the risk as long as you have a long time horizon. That advice is a threat to their financial health.
This article makes points that very much need to be heard. I view today’s dominant model for understanding how stock investing works (the Buy-and-Hold Model) to be truly dangerous stuff for the long-term investor.
I see problems, however, with the idea of being ultra-conservative with the portion of your retirement portfolio that you need to live on and then taking more risks after you have accumulated that amount of wealth. Isn’t that approach going to slow down the journey to the point where you have enough to live on dramatically.
I favor an approach of taking valuations into consideration when setting your stock allocation. The historical data shows that the long-term risk of investing in stocks at times of moderate and low prices is virtually non-existent. On the other hand, the long-term risk of investing in stocks goes sky high when valuations are double fair value; at those sorts of prices (the prices that applied from 1996 through 2008), money market accounts offer a superior long-term value proposition. Why not teach middle-class investors these important lessons? Would that not solve the entire problem?
If we invest heavily in stocks when the long-term return is good, we get the wonderful returns. And if we lower our allocations when risk goes off the charts, we avoid the pain of stock crashes. A big plus is that, if most investors followed this approach, stock volatility would be greatly reduced. Each time prices got out of hand, people would sell and that would bring prices back to reasonable levels. So we would never again see insane bull markets or the insane bear markets that inevitably follow from them.
You make a great point with Monte Carlo simulations. The bigger problem with them are outliers. Years like 2008 when you have a big, unpredictable downward swing. This creates an instance where your 7% failure rate doesn’t mean 700 out of 10,000 employees will be laid off. It means that there’s a 7% chance the whole company will go under and you all will be fired. The outlier has such a big affect that it doesn’t ruin your chances compared to other people but ruins everyone’s chances independently.
Over the short-term, this might be a good strategy. But just as bubble mania causes people to make irrational decisions about their money, post-Depression grandmothers also made irrational decisions.
Like you state, TIPS are based on the government’s official inflation figures, which necessarily a reflection of reality. But the price of a can of Coke 40 years from now will reflect the inflation reality. Therefore, over the long-term, you’re much better off in stocks. Not necessarily certain stock-oriented products. But I’ll wager a share of The Coca Cola Company at today’s moderate price will absolutely trounce the return on any government security over the next 30 to 40 years.
This is an unfortunate example of why stock investing is so risky. You might want to check out what Coca Cola’s real return for the last 40 years was before you place your bet on it for the next 40 years.
In the long term we are all dead, short of that stocks are never not riskier than TIPS.
I’m not young, in fact I’m retired, and it bothers me that so many seem to see retirement as a finite event where all other actions somehow stop. I have one of those 95% successful retirement scenarios but it is not stagnant. The software I’m familiar with provides guardrails that gauge progress AFTER retirement starts. There’s the ideal scenario and the acceptable scenario. If you drop below the ideal and start heading towards acceptable, you modify, adjust, or adapt either your investments or your spending. As long as your income exceeds you base spending needs and there some left over for more adventurous activities don’t fret about that 5 to 7 percent risk – it might shorten your life – and, ironically, MAKE your plan successful.
Hi Mr. Bodie, Thanks for the correction. I’ll ask Flexo to strike through it immediately. I haven’t read your book, and must have gotten the wrong impression of your views from an article somewhere. Regardless, I’m glad I’ve inadvertently agreed with you. Seems like good company.
Apparently you have not read my book, Worry Free Investing. You write:
“A few economists have argued that retail investors should put all their money in TIPS — Boston University’s Zvi Bodie seems to be the loudest proponent of this.”
In my book and in my articles I advocate a strategy identical to the one in your article. Please stop spreading a false impression of my advice. In return I will send you a free copy of Worry Free Investing.
I think it comes down to your risk tolerance. While the market in the last 2 years has been abysmal, someone might can invest 50% of investments in stocks if thier gut ells them it’s ok and they can sleep at night. TIPS can still make up the other 50% if they so desire. You also have to take into account your present age and how much different investments can do for you long term. Interesting post. Good job.
Hi Pop…. great advice here. I was one of those planning to retire in the next few years. I am still going to make it thanks to a great employer funded retirement plan and new personal financial habits that will allow me to live on exactly what you recommended here. However, many of my colleagues were planning to retire this year or next and have had to completely revamp their plans to deal with the losses to their portfolios due to the recession. People don’t think it can happen to them, and then it does.
@RJ, Thanks for the comment. Yeah, it just depends on what you’re willing to gamble. I mean, a 93% chance is pretty good! But unfortunately, it’s not like you get to get to retire more than once if you’re unlucky. It’s infrequent, but Treasury bonds do beat stocks over 40 year periods. Check out this chart: http://bit.ly/bel5W6. I’m not sure which calculation you’re referencing, but generally, the longer your time horizon, the easier it is to invest in low-return but safe investments. So if you have 40 years until you retire, you might get away with saving 25% of your income. If you’re just a few years away, it’s probably too late to make a major adjustment.
@Evan Sure, there are lots of other “middle ground” investments that offer slightly higher returns in exchange for slightly higher risk. It just depends on what you’re comfortable with. The risk of a TIPS investor < the risk of a muni bond investor < a stock investor. By annuities, I assume you mean stuff like equity indexed annuities that you can use as a savings vehicle (rather than an immediate annuity that you'd use when you retire). I haven't seen how those are priced nowadays. A couple years ago, it seemed like there were too many fees involved, but I'd have to look at that again.
@RetirementInvestingToday Yep. We're not going to get something absolutely risk-free until there are bonds "backed by the full faith and credit of God."
In my opinion nothing is risk free even from the government. Just ask patriotic UK people who in 1917 gave money to the government as War Loans.
What about other safe investments?
What about annuities? Muni bonds (not Cali lol)? etc.
If a well diversified portfolio of stocks doesn’t outpace 4.75% over the next 40 years we’re all in trouble. Yes you avoid inflation risk with this strategy, but there is a big opportunity cost for a young investor to get involved with TIPS for this amount of time.
One question I had is when you did the calculation, what time horizon did you use?