The “Black Swan Theory” refers to unexpected events that have dire consequences. Since retirement is associated with a financial world that is not fully understood and the knowledge to make good decisions is not always present, unwelcome surprises do occur. Even without retirement’s Black Swans, small mistakes can lead to unfortunate consequences, but with their unexpected arrival catastrophe can strike.

Here are recent noteworthy “Black Swan” appearances:

  • Two stock market meltdowns in the same decade (2000-02 & 2007-09);
  • The total collapse of the housing and mortgage markets;
  • The lowest level of interest rates in the past 60 years;
  • The most profound economic recession since the Great Depression.

These totally unexpected events did happen and countless millions of retirees suffered as a result. Years of growth and contributions to 401(k)s, IRAs and diversified portfolios were lost. Homes and investment real estate values were cut in half in many locations. Near zero interest rates of bank CDs reduced comfortable incomes to poverty levels. Will other Black Swans appear? Runaway inflation? Serious medical setback? Widespread default of bonds? Currency devaluations? Another Great Depression? The chances may be small but outliers do occur. To expect the unexpected is prudent.

It is generally accepted by the financial world that if you plan to retire at age 70, it is safe to spend 4% of your retirement money annually if you’ve invested it 50% in equities (stocks) and 50% in bonds. According to mathematical computations, this strategy results in less than one-in-twenty chances of running out of money if you live to age 95. Of course there is no guarantee that comes with this strategy, yet it is the conventional wisdom among those that specialize in “market” investments. The 5% chance occurs randomly, and when it does, you could be facing financial Armageddon. If you can’t afford the 5% failure risk, what can you do?

If you have retirement plans, investment/savings accounts, pension income, etc., it would be a good exercise to “stress test” them to see the consequences. For example, what happens if inflation suddenly rises to 10% annually? How would your retirement be affected if stock values dropped by 50%, your 401(k) balance cut in half or your real estate became worth half as much? What if taxes doubled? Broaden the stress test to include the loss of a spouse, an expensive prolonged life-threatening illness or chronic unemployment. Become a temporary pessimist: consider all bad things that could happen and how each would affect you.

The best way to prepare for Black Swans is to have your financial advisor conduct an annual review and “stress test” for unexpected economic, health and financial changes. While these are hypothetical and may never materialize, observing the consequences in the unlikely event they do happen will open your eyes to assessing the risk you are taking with your retirement money. Once you see the risk, you can generally manage it with more prudent investment/savings options, insurance coverage or a change of retirement plans. To have a solid retirement plan you simply must expect the unexpected. The greatest fear of most retirees is running out of money before retirement ends; however, most have not significantly changed their investment/savings/spending habits from those of their working years, nor do they know that there is an easy solution called a guaranteed lifetime income option from an insurance product. Many of today’s retirees are currently exposed to unfortunate financial circumstances because they refused to consider the Black Swan Theory. Let the lessons of others serve as your motivation to obtain professional help. Call your financial advisor to schedule an annual check-up and take your stress test today.

Shelby J. Smith, Ph.D.
December 2010

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