Risk always a question in retirement planning

As the long-awaited day of retirement approaches, most people will need an investment strategy to generate income to cover living expenses. Peace of mind comes from knowing you've put a plan in place that will provide financial security throughout your retirement years.

While Social Security provides a foundational pillar of retirement income, for most it falls well short of covering the entirety of expected expenses. This means most retirees will need to come up with additional savings to invest for retirement income.

This planning requires careful consideration of the risks soon-to-be-retirees face, especially longevity risk and inflation risk.

Longevity risk is the fact you may outlive your retirement savings; inflation risk is the fact that cost-of-living increases may mean your savings cannot maintain your standard of living. Not surprisingly, there are a number of investment alternatives well suited to overcome these challenges.

Here are pros and cons of two of the most popular options.

An immediate fixed annuity is a contract between you and an insurance company in which you agree to hand over a lump sum of money in exchange for guaranteed income. The income is fixed, paid monthly until your death and is not affected by stock market volatility or fluctuations in interest rates. These features make this option ideal for those concerned about longevity risk.

The sharp rise in interest rates over the past 18 months has meaningfully increased the yield of immediate fixed annuities. If a 65-year-old male had invested $100,000 in an immediate fixed annuity in 2020, he would've received $495 per month until death, according to Kelli Hueler, CEO of Hueler Cos. Today, that same $100,000 invested in an immediate fixed annuity will pay a 65-year-old male $671 per month until death. That's a 35% increase in retirement income.

While higher interest rates give immediate fixed annuities increased appeal, an alternative approach is to invest in a well-managed, low-cost balanced fund. Balanced funds invest in a combination of stocks and bonds and can allow retirees to meet their income needs while preserving a high probability of protection against inflation.

If you're willing to accept the unpredictability of year-to-year market fluctuations, you'll be facing what industry experts call "sequence of returns" risk. This is the risk of experiencing a significant loss early in your retirement journey which impacts your portfolio's long-term income production. Despite this risk, this approach offers meaningful long-term advantages.

To put the appeal of balanced funds and the risk-return tradeoff they represent in perspective, it's reasonable to consider a scenario where a balanced fund generates an average long-term (i.e. multi-decade) annual return of around 8%, which is a conservative estimate for some of the best funds in this genre.

In this scenario, a 65-year-old investor who puts $100,000 into a balanced fund, earns 8% per year, and withdraws 4% per year for income, could expect monthly payments averaging $638 over a hypothetical 30-year retirement period. Importantly, for the same investor who lives to the age of 95, there's the potential for over $300,000 to remain to offset any future inflation or pass on to heirs.