What are the risks associated with early retirement?

Retiring earlier sounds like a dream come true for many - more time for hobbies, travel and family. But before you take that step, it's important to understand the potential risks of early retirement. Below, we discuss the main concerns and how you can manage them. At Vive, we're ready to help you with sound financial planning so you can enjoy your early retirement carefree.

Financial uncertainty

When you stop working earlier, you have to live longer on your savings and pension assets before you are entitled to AOW and any additional pension. In other words, your bridging period until the official retirement age is longer, and you need a larger financial buffer to finance these extra years. If you underestimate this, you could be in trouble later.

Tip: Make a detailed financial plan for your early retirement. List all your expected expenses and income for the years until your state pension. Be realistic and include a margin of safety. Consider hiring a financial advisor (such as the experts at Vive) to work through your situation and create a feasible plan. That way you'll know exactly how much equity you need and whether you're on track to retire early.

Inflation

Inflation can have a big impact on your retirement assets, especially if you have to bridge longer periods of time. Inflation means that the purchasing power of your money decreases: over time, you can do less with the same amount of money. If you stop working 10 years earlier, prices will be higher at the end of that period because of inflation. So you will need more money than the nominal amount you have now to afford the same lifestyle later.

Tip: Take inflation into account in your planning. Choose investments or savings products that try to keep up with or beat inflation. Consider investments that have a higher expected return than inflation - for example, a well-diversified stock portfolio, real estate or inflation-linked bonds. That way your assets retain more of their value. Update your budget annually with an inflation rate to keep your plan up-to-date.

Unexpected expenses

Life is unpredictable. Even during your early retirement, unexpected expenses may crop up: a medical procedure that is not fully reimbursed, a major repair to your home or car, or other setbacks. If you stop working earlier, you may have less flexible income to absorb such blows.

Tip: Have an emergency fund (buffer) large enough to cover unexpected expenses separate from your retirement pot. A common rule of thumb is 3-6 months of expenses as a buffer, but in the case of early retirement, you may want to be on the conservative side (say, toward 12 months of expenses) because your income can no longer be supplemented by working. This contingency fund prevents you from having to sell your investments at an unfavorable time or run into financial trouble in the event of a setback.

Investment risks

When your assets are invested (in stocks, bonds, funds, etc.), you are always at market risk. The market can disappoint: price drops or even crashes. If you retire early, you rely on your assets. A firm bear market (falling market) can affect the value of your portfolio and perhaps force you to adjust your plans (e.g. go back to work or live more frugally, after all).

Tip: Diversify your investments to spread risk. Don't have "all your eggs in one basket"; invest in different types of assets (stocks spread across sectors and regions, some bonds, etc.). Also, as you approach early retirement, consider structuring your portfolio a little more defensively than during your accumulation phase - that way you reduce the impact of a market correction on your immediate living expenses. If necessary, talk to a financial advisor about your investment strategy before and during retirement so that it fits well with your goals and risk appetite. The goal is that you can sleep easy knowing that your investments can take a beating.

Longer lifespan

We are getting older on average. Chances are you're living longer than you might have originally estimated. Early retirement means that your retirement assets have to last even longer. For example, if you stop working at 62 and turn 90, you'll have to bridge 28 years - significantly longer than someone who stops working at 67 and turns 90 (23 years). Underestimating your longevity can mean that you will be short of money later in life (in your 80s).

Tip: Prefer to be overly cautious in your planning by assuming longevity. For example, calculate what you would need if you lived to be 95 or even 100 years old, instead of, say, 85. That way you build in an extra buffer. Make sure your plan is flexible enough that, should you get older than expected, you can adjust accordingly (for example, spending a little less per year if necessary). After all, it's better to have too much money left over in old age than too little.

Reduced allowances and tax benefits

When you stop working, you may lose certain allowances or tax credits that are tied to having income from work. Think of employment tax credits on income taxes - they expire when you no longer have wages. You also no longer accrue new pension rights through an employer, which is indirectly a kind of missed "bonus." In addition, you may have to deal with higher health care premiums (your employer no longer contributes) or possibly miss accruing vacation pay. All these factors can mean that you have less net to spend than your gross planning suggested.

Tip: Make an overview of all financial benefits that will disappear if you stop working before retirement age. Examples: no earned income tax credit (reduces net income), possible loss of entitlement to certain benefits because your assets increase when you retire (e.g. housing benefit may be lower if your savings exceed a limit). Consider how you can compensate for this in your plan. Sometimes the answer is simply that you need a little more equity. In other cases, you can actively do something: e.g., temporarily use a bridging scheme such as the Early Retirement Regulation (RVU) through your employer (where you can receive benefits up to 3 years before AOW, if your employer cooperates). Get informed about this so you make the choices with your eyes open.

Be realistic

Early retirement offers you wonderful leisure and freedom, but it is crucial to be aware of the financial risks involved. The good news is that with sound financial planning and a few precautions, these risks are quite manageable. Establish a realistic plan, adjust it if necessary, and take measures such as buffer building and spreading investments.