Contingency planning for retirement

Contingency planning for retirement involves preparing against spending shocks. During retirement, unexpected expenses and shocks can come, for example, from health issues including long term care needs or major dental expenses; major unplanned home repairs; the death of a spouse (funeral costs and potentially reduced retirement income afterwards); divorce; long-term help to children; or victimization by fraud/scam. According to research from the Society of Actuaries, the majority of retirees are impacted by spending shocks and unexpected expenses.

Planning steps include (1) assessing the financial risk exposure; (2) defining financial risk abatement capacity; (3) choosing to cover each relevant risk with either insurance or dedicated wealth, which can include housing wealth and a contingency fund. The latter is a reserve of financial assets to protect against spending shocks, and serves the same function as an emergency fund during the working years, but the risks to be covered are partly different, and the dollar amount needed may be more.

This article reviews the main types of spending shocks during retirement; integrating contingencies when planning for retirement; using insurance versus dedicated wealth (self-insurance) to protect against contingencies; and how much to place in a contingency fund, versus other reserves like housing wealth. The article also provides some ideas about how to invest one's contingency fund.

Spending shocks before and after retirement

Pre-retirement

During the asset accumulation phase of the lifecycle, a good contingency plan typically consists of an emergency fund to cover job loss, house repairs, car trouble, and the like, as well as sufficient life insurance, disability insurance, home insurance, auto insurance and perhaps a "small losses fund" if self-insurance is being employed, for example to increase deductibles on home and auto insurance.

First phase of retirement

During retirement, many of the risks are the same (house fire, car accident, leaky roof), but some risks are gone, like losing employment income from job loss or an accident/disability (assuming the retiree does not work anymore). Yet new risks appear or increase.

Occurrence of shocks

The following shocks are the main ones (more than 5% occurrence) reported by retirees up to 80 years old, or their spouse, in 2015, in the US and Canada:

Shocks reported by retirees up to 80 years old or their spouse

Event	Reported by
Major home repairs/upgrades	28%
Major dental expenses	24%
Significant out-of-pocket medical or prescription expenses from a chronic health condition or disability that did not limit their ability to care for themselves	20%
Drop in home value of 25% or more	16%
Illness or disability that limited their ability to care for themselves	15%
Running out of assets	15%
Sudden loss in the total value of their savings of 25% or more due to a fall in the market	14%
Family emergency that impacted the amount of money they were able to spend on other things or required using 10% or more of their savings	12%
Death of a spouse or long-term partner during retirement	10%
Loss in the total value of their savings of 10% or more due to poor investment decisions or a bad investment	9%
Victimization by fraud or scam	6%

Shocks with a less than 5% occurrence among retirees surveyed were, in decreasing probability:

• bankruptcy
• loss of home through foreclosure;
• significant damage to or loss of a home due to a fire or natural disaster;
• divorce during retirement;
• loss of capacity requiring someone outside the household to manage your money.

Note that these figures are available sorted by household income (figure 66), by sex (figure 67), by age (figure 68) and by household assets (figure 69) in . Some probabilities are strongly dependent on income and assets (e.g., running out of assets, family emergencies, bankruptcy). Other shocks are strongly age- or sex-dependant (death of a spouse). It is worth looking at those tables to get a better idea of the main risks for your particular situation, or over time.

Effect of shocks on assets

In terms of the total effect of shocks on assets, among retirees who experienced at least one event, over 20% of all retirees lost 50% or more of their assets as a result of all shocks combined:

These numbers are again presented by household income (figure 77), by sex (figure 78), by age (figure 79) and by household assets (figure 80) in , and those tables are worth looking at.

Late retirement

The same retirees surveyed by the Society of Actuaries were also asked what shocks either of their parents had experienced, to get an idea of risks for people up to their 80s or 90s, and the main shocks (>5%) reported were:

Shocks the retirees' parents had experienced

Event	Reported by
Illness or disability that limited their ability to care for themselves	58%
Significant out-of-pocket medical or prescription expenses from a chronic health condition or disability that did not limit their ability to care for themselves	25%
Loss of capacity requiring someone outside the household manage their money	24%
Running out of assets	16%
Family emergency that impacted the amount of money they were able to spend on other things or required using 10% or more of their savings	9%
Major dental expenses	9%
Drop in home value of 25% or more	8%
Major home repairs/upgrades	8%
Sudden loss in the total value of their savings of 25% or more due to a fall in the market	7%
Loss in the total value of their savings of 10% or more due to poor investment decisions or a bad investment	7%

Shocks with a less a than 5% occurrence among retirees' parents were, in decreasing probability:

• sudden loss in the total value of their savings of 25% or more due to a fall in the market
• victimization by fraud or scam
• significant damage to or loss of a home due to a fire or natural disaster
• divorce during retirement
• bankruptcy
• loss of home through foreclosure

Death of a spouse or long-term partner during retirement is not listed for the surveyed retirees’ parents, but must be much higher than 10% (everybody dies eventually).

Contingency planning for retirement

Planning generally focuses much more heavily on the expected than the unexpected. But life is a mixture of both, and how well retirees handle the unexpected is a big determinant of how well they will do overall.

Given those possible events, how do you plan? In general, risks can be assumed, or reduced (avoided, mitigated, or transferred). Another way to think about contingency planning is that risk can be addressed in three ways:

1. buy insurance for specific risks;
2. self-insure through wealth (including a contingency fund);
3. reduce the exposure when possible.

An example of reducing risk exposure is that diet and exercise can reduce health costs, at least during the first phase of retirement. But most of the ways to address risks cost money and should form part of financial planning for retirement.

Including contingencies in your plan

There are many ways to envision retirement budgets and plans, but one that includes a contingency fund explicitly is a four layer pyramid, starting from the base:

• Base Fund – for essential retirement living expenses.
• Contingency Fund – for hedging against significant, often unpredictable events.
• Discretionary Fund – for spending above the essential levels.
• Legacy Fund – for inheritance and charitable purposes.

Or, using the four "L"s of retirement goals:

This model clarifies that the contingency fund (as well insurance to cover certain risks, and other dedicated assets) should be conceptually separate from the resources planned for regular retirement living expenses, including essential expenses (housing, food, …) and discretionary expenses (travel, gifts, …).

It also shows that the contingency planning should be potentially put in place before funding for discretionary expenses is established, because it is important to protect the first goal of securing essential expenses, if the retiree is to remain retired even if/when spending shocks happen.

Contingency planning framework

Yanikoski offers a very useful contingency planning framework, with four steps:

1. assessment of financial risk exposure,
2. defining financial risk abatement capacity,
3. assessing financial products (insurance) for risk abatement (versus dedicated wealth),
4. reality test.

Yanikoski's report contains details about each step. He makes it clear that purchasing insurance, or using self-insurance (through dedicated wealth, including in a contingency fund), will mean that this money will not be also available to spend on regular living expenses: there is a trade-off between lifestyle and financial risk abatement.

Long term care planning

Main article: Long term care planning

Many ageing Canadians will experience long term care events. Some of those events can last several years and have large costs, so readers are encouraged to pay particular attention to this aspect of contingency planning.

Insurance versus dedicated wealth (self-insurance)

One you have decided what portion of your wealth to dedicate to regular retirement expenses, versus contingency planning (risk abatement), i.e. the steps 1 and 2 in the Yanikoski framework, you can look at whether it makes sense to purchase insurance, or to self-insure for certain risks, i.e. step 3 in the framework.

Some risks can be quantified and mitigated (hedged) by sharing the risk with many other people. This risk pooling is typically done by governments or insurance companies. For example, the risk of dying old and running out of assets (longevity risk) can be addressed using life annuities. Other risks that can be mitigated using insurance include house fires (home insurance), car accidents (auto insurance), health care expenses not covered by the public system (health insurance, dental insurance), long term care not covered by the public system (long term care insurance), and funeral expenses (through permanent life insurance).

While these risks can potentially be mitigated through insurance, they don’t always have to be: it is up to the retiree to decide, the alternative being to self-insure by setting aside a portion of one's wealth, including financial wealth (through a contingency fund) and other forms including housing wealth.

The very wealthy can perhaps insure or self-insure for all risks, but middle to upper-middle financial class households have "enough resources either to insure against only some risks or to insure in part against all risks". Money spent on a specific insurance policy mitigates a particular risk, but the dollars spent on premiums "could instead be used to help cover other contingencies" through self-insurance (contingency fund) or other insurance polices addressing different risks. So there are trade-offs involved here as well.

If (1) insurance is cheap and readily available, (2) the consequences would be large to catastrophic and (3) the probabilities of the event are low, insurance policies are often the way to go. For example, as seen above, the probability of reporting significant damage or total loss of one’s home (e.g. house fire) is only about 3% in the SOE data, but the consequences would be completely unacceptable at most income/asset levels, and insurance is relatively cheap if the deductible is set high, so this is a clear-cut case. Other categories are much less obvious, including long term care insurance, dental insurance, on so on, and have to be evaluated, on their own and versus insurance against other risks.

The advantage of self-insuring (having enough dedicated wealth) is that the wealth reserves do not have to be spent on a specific type of event: dedicated wealth covers all risks, not only a specific one, and it even covers those risks for which no insurance is available. But self-insuring may be less cost-efficient than purchasing insurance for certain categories of events (like the house fire case), so a combination of dedicated wealth and insurance is likely optimal.

Contingency fund versus non-financial wealth

For self-insuring against contingencies, wealth can be financial (contingency fund) or non-financial (e.g., housing). Planning to use housing wealth, if available, to cover at least some contingencies, perhaps including long term care and major health issues, reduces the amount of financial wealth to be placed in a contingency fund.

Tapping into housing wealth (the value of your mortgage-free home) can be done through a home equity line of credit (HELOC) or a reverse mortgage. Another way to access some home equity is to downsize or to move to a less expensive housing market, although this is a long process with many fees involved; this is probably best contemplated at the start of retirement than as a later source of funds for a sudden long term care expense, for example. If no major spending shocks happen during retirement, then the home equity will remain untapped and can be transferred to your heirs instead. The home is viewed as a buffer asset.

Another potential buffer asset is a permanent life insurance policy, if already in place. But this is likely not a sufficient reason to establish such a policy in the first place.

The contingency fund

Matching assets with goals

Subdividing one's assets into several "funds" or "accounts", earmarked for specific purposes, can be seen as mental accounting, which is often presented as a type of behavioral bias (money is fungible). One advantage of doing so explicitly, however, is that it is easier to decide how to manage an "account", and how much/when to spend from it, if the goals are clear: assets are matched with goals.

For example, retirees who view all of their assets as "one pot" can be legitimately concerned about longevity risk, i.e. living a long life and outliving their assets. Because they have not separated their assets by goal, they may feel like they can spend less: "in a sense, they believe all of their investments must provide liquidity for contingencies". Their "contingency" mental account still exists but is "amorphous" rather than explicit. By making the contingency fund explicit, and establishing funding for basic expenses and contingencies first, one sees more clearly how much is left for discretionary expenses and legacy goals.

How to invest the contingency fund

In the pre-retirement period, the most common advice is to place one's emergency fund (typically 3-6 months of expenses) largely, if not exclusively, in cash. The obvious reason being: this is money for emergencies, you want to be 100% sure it is there when you need it. For example, in case of job loss during a recession and simultaneous stock market crash, the entire emergency fund could be consumed within 3 to 6 months; there would be no time to wait for a stock market recovery.

During retirement, the contingency fund might be many times larger, and cover several types of potential events (long term care, major dental expenses, major house repairs, ...). In this context, a single event/shock is unlikely to require using the entirety of a large contingency fund within one year. So should the entire contingency fund, perhaps hundreds of thousands of dollars (if self-insuring for long term care, for example), still be completely invested in cash? Holding large cash reserves for several decades is potentially very costly as this is the asset class with the lowest expected long-term return (e.g., ). In a non-registered account, after taxes, the return of cash may not be enough to maintain purchasing power (i.e. match inflation).

Therefore, in some cases, a diversified portfolio (stocks and bonds), combined with cash reserves, could potentially be used, although this is a personal decision. Some investors might want to cover a certain number of months or years (or a dollar amount) of potential contingencies with cash reserves, and put the rest of the contingency fund in a diversified portfolio, perhaps using an asset allocation ETF for maximum simplicity. The asset allocation of the diversified portfolio would reflect the investor's general attitude toward portfolio volatility, but would probably be more conservative than that of the "discretionary fund" (see the pyramid above), since the aim for the contingency fund is closer to asset protection than to aggressive growth. In case of a major long term care event, the contingency fund would also be consumed more quickly (several years) than the discretionary fund (decades), meaning less time would be available for a stock market recovery.

What the contingency fund is not

There is an idea that a cash buffer, or buffer assets in general, can be used if stock markets are down to avoid spending from the portfolio over a certain period and reduce sequence of returns risk. This is part of producing regular retirement income through a "bucketing" or "cash wedge" strategy and this is not what is being discussed here.

See also

• Outline for pre-retirement investors
• Outline for investors in early retirement
• Outline for investors in late retirement

Further reading

• Financial Wisdom Forum topic: "Contingency fund during retirement"
• Financial Wisdom Forum topic: "Blackrock whitepaper on spending in retirement" (discusses why some retirees have growing portfolio balances over time: they are keeping reserves for medical expenses, long term care, etc.)
• Financial Wisdom Forum topic: "Emergency Fund and Retirement"

External links

• Society of Actuaries, Women and Post-Retirement Risks, 2018