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What is Risk in Life Insurance?
Risk is a funny thing. Most people have some inherent idea about what it is and what it entails. But few of us really think about how it affects our lives or give much thought to just how much it exists. Perhaps this is because we want to be naturally optimistic. Or perhaps it’s simply because thinking about the number of risks we face for a task as simple as getting to work each day would make us all clinically depressed—good for Pfizer, bad for our pocketbooks.
In probability theory, we often learn and talk about types of risks and their measurability. Some risks are easily quantified, like the probability of losing a bet on a slot machine in Vegas. Others are a tad more complicated to calculate, like the risk of having your house burn down tomorrow.
For risks that present a higher degree of complexity or challenge in crunching the numbers, we generally assign values to them in vague estimations. For example, I can’t tell you precisely what the probability is that my house will burn down tomorrow, but I’m confident that it’s pretty low.
When it comes to retirement planning, there are a number of risks the hope one day retiree will face throughout his or her journey to eventual golden girls-hood. There are some very obvious ones that anyone with a license to sell securities is likely to discuss like market risk, interest rate risk, systemic risk, and liquidity risk. And there are a few others that go beyond the typical textbook for level one financial advisor-dom like longevity risk and cash flow risk.
My goal today isn’t really to add a bunch of new types of risk to your list of doom and gloom, but rather to alter just a bit the paradigm under which we operate regarding risk.
Timing Risk among the Financial establishment
A form of risk that is up for debate among the financial planning establishment is the notion of timing risk. For the more educated on the topic of personal finance, this one is probably pretty self-evident, but for the less equipped among you, I’ll assist with a little explanation.
Timing risk is simply the risk you face when entering a market. The risk involved is the idea that you’ll enter the market at an inopportune time—like when the market is really high—and you’ll lose money as a result of a market contraction (i.e., buy high sell low).
There are many in the bond and equities sales world—especially among the more mutual fund-focused crowd—who would tell you that timing risk is avoidable with time and a nifty strategy known as dollar cost averaging. To these people, time averages out returns, so fearing a market entry is foolish because you’re forsaking the opportunity to make money in the long run. Sounds like a really good pitch to sell some investment products, but I’ll admit that there is sound logic behind their averaging out argument, at least until you retire.
What is Retirement Timing Risk?
Despite what most in the investment sales world will tell you, you don’t have unlimited time you can use to wait for the market to come back, even if you are only 22 years old. Whether we like to admit it or not, there’s a relatively finite number of years between our first and last day at the office. And that 40 to 50 years will define how we finish out our lives. You only get one crack at it.
So what’s the probability that your investments will go bust?
That’s somewhat simpler to calculate than you might imagine—or at least it’s arguably easier than calculating the probability that I’ll be sifting through the ashes of my house tomorrow, assuming your investments are largely in stocks. But that specific question isn’t the one I really care about, as retirement timing risk is less about the probability of a market contraction and much more about the timing of such a contraction.
When the Market Brings you a Bear for your Retirement Party…
If the market brings you a bear for your retirement party, cry. Bear markets that strike early in retirement can be disastrous. We’ve known this for a really long time, but most of the investment world is pretty silent on the subject as it doesn’t have a really good answer for avoiding the consequences.
This is what I mean by retirement timing risk. We can’t control when the market dips will take place, and as such, we often can’t prevent a dramatically altered retirement if the market takes a bad turn around the time we’ve crossed out that last day on the calendar.
How Life Insurance Helps Retirement Problems
Life insurance is a low-risk asset. We’ve mentioned this oodles of times. And while most of you will accept that for what it is, reliable, the fact of the matter is this low-risk profile makes it a star student when it comes to income generation. Why? Because it’s not affected by market dips.
If you give me a million dollars and a guaranteed 2% yield indefinitely, I can guarantee that you won’t be broke after 20 years if you withdraw $50,000 per year from the account. That’s a mathematical fact. And the guaranteed rate on most whole life contracts is better than our 2% return (and all of this ignores dividends).
Life insurance works so well for income purposes because it’s so incredibly stable. I’ve commented that you won’t generally be excited about it, but you’ll be happy it’s around when the rain comes pouring down.