Benefit & Retirement Plans and Risk

Planning for retirement is important to provide sufficient assets and funds that help one live a smooth life after retirement. There are several retirement structures which include pensions, annuities and social security which are financial frameworks where people save money for retirement. People deposit money in a pension plan to generate income for them when they retire. Qualified plans are pension structures that are in line with established government regulations and provide significant tax benefits. Qualified plans are of two main types: defined contribution and defined benefit.

Defined contribution plans places an amount of money in the pension regularly. The total amount available on retirement depends on the sum contributed plus the returns on that money. This kind of plan is often portable to different jobs or retires. Examples include company profit sharing plans and IRAs.

On the other hand, in defined benefit plans an individual is provided with a given stream of income throughout the retirement. It acts as an annual income for retirement. The amount available in retirement depends on the time spent with the corporation or other organizations and on the salary period around the retirement. Examples include annual income by a company or union and social security.

Defined benefit plans calculates benefits at the end of working period and or salary while the defined contribution plans calculates benefits at the beginning of working period contributions.

Retirees plan for a good standard of living by investing and saving in different retirement structures. However they are faced with many risks namely: investment risk, longevity risk, inflation risk, and health risk. These risks are discussed below.

Investment risk rise due to the possibility of having lower than average returns. Many companies’ returns are declining day by day and this is a crucial to retirees due to withdrawal risk. Withdrawal risk is the risk of taking money to fund retirement given depressed asset prices. When the market is depressed any fixed amount withdrawn would result in an extra percentage of portfolios being withdrawn which is lost forever. Thus, there is less money left to yield investment income. Defined contribution plans are much more affected by decline in assets as compared to the effect on defined benefit plans. Withdrawal risks can be reduced by taking money from the bond portfolio rather than the liquid stock portfolio since bonds tend to be less volatile.

Longevity risk is the risk of death occurring long before or after it is anticipated. There is a risk in dying before expectation, as other household members who were dependent on the deceased’ income will become financially unstable. Likewise, living longer than expected would risk financial constraints when retirement resources are depleted. Despite this, being healthy would guarantee you a long life full of pleasure in retirement. Due to these uncertainties in death therefore, most people provide resources for a longer than average life. Longevity risk can be reduced by use of annuities as one cannot outlive his annuity payments.

Inflation risk occurs when retirees’ salaries are adjusted to take into account inflation yet the retired do not have a salary to offset the general increase in costs of living. Most retirees only depend on flat payout company pensions and fixed payout bonds. Inflation therefore increases their withdrawal costs leaving fewer dollars to generate investment income. This leads to a downward spiral in saving as they try to keep pace with the now reduced income and their standards of living. This risk can be reduced by investing in inflation indexed bonds, having significant equity positions and indexed insurance policies for housing.

As one ages, health risk increases and there a risk of large unreimbursable costs arising. Deaton (2003) pointed out that an individual lifetime income is significantly reduced by illnesses in old age due to the fact that individuals cannot fully insure their earnings against health risks. Elderly people have high medical costs which are mostly expensive enough not to be covered by Medicare. This forces them to have a lower standard of living to cater for part of the costs. Some people thus take Medigap insurance which pays either part or all the cost of drugs and certain supplemental medical costs. The elderly also deal with high costs of long term care. They need partial or full assistance from people either in their homes or in a facility like a nursing home which the government’s assistance in this area is mostly scarce. This risk can be resolved by using long-term care insurance to meet part of the cost, inflation riders’ policy and having significant cash reserves.

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