The traditional path to retirement is first saving a nice nest egg, and then retiring to live off of your savings, supplemented by Social Security benefits. Easy as pie!
But in fact, retirees often face financial shocks including extraordinary healthcare expenses and widowhood, particularly after reaching age 75, according to Boston College's Center for Retirement Research (CRR). And those shocks might actually be greater for retirees in the future. Let's look at why.
What are financial shocks for seniors?
The CRR defines "financial shocks" as events that happen to elderly folks that cause either a sharp climb in expenses, or a significant drop in income. There are two financial shocks most retirees can expect at some point during their lifetime, and knowing about them can help you plan for them, making them less shocking.
The first potential financial shock is a sudden rise in healthcare expenses. Expenditures are already high for older people; a couple retiring at 65 is estimated to need $399,000 over their retirement to pay for healthcare costs, according to the Employee Benefit Research Institute. Over a 25-year period, that's about $15,960 annually. A sudden spike, defined as medical bills of more than $400 and greater than 1% of household income in a year, can severely cripple the budget of a fixed-income household.
Shocks from spiraling healthcare costs can be more frequent as a person ages, because older people are more likely to be diagnosed with conditions that are expensive to treat. Among families 75 or older, 23% experience a financial shock related to healthcare expenses each year, 21% of families between 65 and 74 do, while 9% of 18 to 24-year-old families do, according to the CRR.
The second financial shock stems from losing income when a person enterd widowhood. Widowed people receive between 50% and 62% of the retirement benefits received by a couple, but they need roughly 79% of that income to maintain the same living standard.
Compounding these shocks is the huge percentage of disposable income retirees already use to pay for necessities. Roughly 77% of current retiree income for people between 65 and 74 is spent on just five things: Housing, healthcare, food, clothing, and transportation; The percentage rises to 79% for people 75 and up.
That only leaves about 20% of income available to pay for anything outside of bare necessities. If a retiree needs more money, there aren't many areas where spending can be reined in without causing hardship.
The impact of these shocks might increase in the future
Fortunately, the CRR believes that current retirees can withstand these shocks. But future retirees are not in the clear.
Retirees over the next 25 years and more will need to rely more on their own retirement savings compared to previous generations, who relied more on defined contribution pensions. Future retirees may also not have saved enough personally for retirement, either.
For example: Generation Xers' retirement income at 67 may replace from 6% to 21% less of their working income than the retirement income of folks 70 and older. Even the cohort slightly older than Generation X, which the CRR dubs "trailing boomers" (distinctive from leading boomers) may see their retirement income replace from 8% to 18% less of their income at 67 than older folks.
The solution: Raise retirement income and reduce expenses
So how can retirees plan to avoid or mitigate these financial shocks? The CRR recommends several solutions that aim to either raise income or reduce expenses in retirement.
The first is working longer. Working into the retirement-age years is already becoming more common. Having income from wages or a side hustle in retirement can provide greater financial health down the road.
Working past your full retirement age (FRA) as defined by the Social Security Administration (SSA), even until age 70 when the bonus for delaying maxes out, will boost your Social Security payments. The amount you're entitled to climbs 8% for every year a person delays starting to claim their benefits past thier FRA. (FRA ranges from 65 to 67, depending on your birth year; find your FRA here.)
The second solution is purchasing a joint deferred lifetime annuity. Annuities are sold by insurance or investment companies, that set up the annuity and invest the money you pay for it.
A deferred annuity is also called a "longevity annuity" or "longevity insurance," and it starts paying you a defined amount at a specific future date. "Joint" means that the annuity is paid to the couple. If one spouse dies, the annuity keeps paying the other spouse. "Lifetime" means that payments will continue for the rest of the recipient's life.
Deferred annuities can be set up to begin payments at any age. If you're most concerned about financial shocks beginning at 75 and lasting through your life, for instance, you can choose 75 as the date you begin receiving annuity payments. Retirees can strategize by relying on retirement savings for part of your retirement (say, from the ages of 67 to 74), and then have a deferred annuity beginning in another stage.
Annuities can be expensive, but deferred annuities cost less than variable or immediate annuities, because the money has more time to increase in value. The more years you have until you begin receiving annuity payments, the cheaper they will be.
The third solution is reducing your living expenses. Downsizing can save you big on housing costs and possibly taxes. Plus, retirees who move into a smaller home can use the proceeds from selling their house to cushion against financial uncertainty, insulating them from shocks.
Moving to a lower-cost-of-living area can also reduce real estate expenses and property taxes, further paring down expenses in retirement. For a list of the best places to live for retirees, with relatively low costs and low taxes, see here.
Financial shocks in your older age can seem awful, but planning is everything. Act now to secure your retirement and you'll be relieved of your worries about encountering a financial shock in retirement, because you'll be prepared.