Retiring on time is no accident. It’s the work of long-term thinking and careful planning, whether you go about it on your own or hire an advisor to help out.
Even those who do hire advisors would be better served to understand the mechanics of saving and investing. Think you know a thing or two about the matter? Take this five-question financial savvy quiz and find out:
1. A retirement account of $200,000 means you can safely withdraw what amount on an annual basis and expect it to last for 30 years?
Answer: C. $8,000. Financial advisors counsel taking no more than 4% of your retirement savings per year ($200,000 x 0.04 =$8,000). Conservatively invested, that level of withdrawal means the money should last for three decades. Take more, and you are counting on a higher, and thus riskier, investment return. Or you run out of money sooner.
2. The longer I wait to take Social Security, the more I will get paid once I begin benefits.
Answer: A. True. Many people take their retirement benefits beginning at age 62, the earliest possible age. However, if you were born in 1943 or later you will be paid an estimated 8% more money for each year you wait until the ultimate retirement age of 70 (your “full” retirement age may be sooner). You are likely to collect for fewer years, it’s true, but you might want to work for a few years past 62 in order to build up private retirement savings in a 401(k) or IRA.
3. A reasonably risk-adjusted portfolio that holds more stocks than bonds is likely to double your investment within what period of years?
a. Around 12 years
b. Around 10 years
c. Around 4 years
d. Around 7 years
Answer: B. Around 10 years. Many investors nearing retirement today have become used to stock market returns of 10 percent or more and doubling every seven years. However, the long-term return on stocks with dividends reinvested is about 6.6%. Held with bonds and rebalanced regularly, such a portfolio is likely to double your money in 10 years, not seven.
4. My 401(k) plan at work has fees that cost me what percent of my retirement savings balance every year?
a. Zero, it’s free.
b. Less than a half of 1%.
c. About 1%
d. Easily more than 1%
Answer: D. Easily more than 1%. In fact, 401(k) plan fees average 1.5%. Large-company plans tend to be the least expensive, while small company offerings can cost as much as 3.86%. That money is deducted from your total portfolio balance, not from the potential earnings in a given year.
5. The single most important investment I can make for retirement is to…
a. Own good life insurance
b. Have a paid-up mortgage
c. Maximize tax-deferred and tax-free savings
d. Build a cash emergency fund
Answer: All of the above, but mostly C. Maximize tax-deferred and tax-free savings. Life insurance is useful if something happens to you, but that is unlikely. Paying off a mortgage is great, but your interest rate is probably very low and there are tax benefits to paying it down slowly. Everyone needs a cash emergency fund of at least three months (six months is better). However, all of these pale in comparison to a 401(k) or IRA which earns you a tax break now or is tax-free later and compounds at a market rate of return.
Feeling better about your financial savvy? Great! Didn’t do so well? I recommend a trip to the public library. Try The Elements of Investing to start. It’s a short read and easy to understand, yet the concepts are important and timeless. Then start making choices that will get your retirement game plan on track.
Can you beat the market these days? Should you even try? Increasingly, the resounding answer for retirement investors is “no” and “save your money.”
Wall Street blows a lot of cash on the idea that everyone should somehow beat the market. Try $600 billion a year in fees. Yet the financial research theory, now decades old, has finally proven true. Your odds of getting a better return than the overall market are now vanishing small — less than one manager in 100 can do it.
Could you pick that manager? Does he or she even take clients with your level of retirement savings to grow? Probably not.
Could you do it yourself instead and save the money? Only if you believe that you have the skill and the stamina to outlast all of Wall Street and beat them and the market consistently, year after year. The data shows it’s just not true, for them or for you.
The University of Maryland took a look at what’s called “true alpha,” that is, a market-beating return that cannot be attributed to chance. You know the old story of the stock-pickers who use a dartboard. Every few years, someone sponsors a contest with 5th-graders, or a cat pawing at toys or something utterly random, like coin flipping.
The resulting “nonprofessional” portfolio inevitably wipes the floor against highly paid managers, making the point quite clear: The managers are in the business of packaging sheer chance wholesale and marking it up to sell retail.
It wasn’t always so. Before 1990, there was a pretty good opportunity to beat the market. Then, 14 out of 100 managers could do it consistently. Soon, though, index funds and ETFs really took hold. Computerized information became more widely shared and constant. Many more mutual funds entered the market.
The result was the rapid destruction of the ability of talent to win over coin-flipping. Yet the “talent” is still in business, still charging high markups and still maintaining the faulty argument that investments must be picked and managed.
Are managers necessary? Not when just 0.6% of managers can pull off a true win. Think of it this way: If that tiny minority of traders is able to beat the market, by how much will they do so? Not much, it turns out, once you subtract their fees.
Retirement photo finish
Why not just own the market, get second place in a photo finish and keep those fees in your portfolio, where they can do you some good by compounding? That, in essence, is the argument of index funds.
Unsurprisingly, index funds and index-style exchange-traded funds (ETFs) have exploded in popularity since. What’s more, price competition has set in, driving down the cost of holding an index ETF to well under one-tenth of 1%.
That move represents the savings of hundreds of billions of dollars, money that remains in the accounts of investors themselves. And that’s how retirement is reached these days by prudent, long-term investors.
Investors love the idea of being able to predict the future. People who wouldn’t be caught dead engaging a roadside psychic or fooling around with tarot cards nevertheless are convinced that some months are “good” for stocks and some months are “bad.”
We saw this happen once again in October of this year. Pundits far and wide wrote in the late summer and early fall that the market was due to correct, if not crash, in October.
How would they know that? They wouldn’t, but as it happens three of the biggest market collapses in history occurred in October: The Panic of 1907, the Great Crash of 1929 and Black Monday in 1987.
Convincing, right? Yet there’s really no evidence to support the idea that October is to blame. Almost every month has its periodic declines at some point in history. Like the “June swoon” and the “Santa Claus rally,” these trends are reinforced by repetition: They tend to happen because we expect them to happen.
Crowd psychology is a funny thing. If you look at last month, our most recent October, you see a huge slump in the S&P 500. Nevertheless, there were similar (albeit not as deep) slides in February, April and August.
Oddly, though the market recovered from the October decline this year and went on to new highs, nobody talks about November being a perpetually “great” month for investing.
Why would they? The presumption by many investors is that stocks will rise in the future, a trend supported by long-term statistical studies. In fact, equities have beaten all other investments handily, returning 6.6% annually.
That’s about twice the rate of growth of the economy, a result researchers suggest is a reflection of reinvested dividends. Put another way, held for the long run, stocks keep up with the economy in terms of appreciation and return double that on reinvested capital.
Yes, an individual investor can be caught out when markets crash. But the risks can be and should be limited.
First of all, own the right level of exposure to the stock market. If you are investing for the short-term, cash or money market funds are more appropriate. If you are investing for just a few years, you might be better off in bonds.
But if you expect to own an investment for decades, stocks are the right choice. As your time horizon shrinks and you need the money for living expenses, that’s when you dial down your risk and hold less in stocks.
In the meantime, let the Octobers come and go. They don’t mean anything to serious retirement investors. Focusing on the occasional slip in equities is a recipe for waiting, and waiting is a sure way to miss the upside from prudent, long-term thinking.
Record-setting markets got you down? You’re not alone. Anyone who remembers the dot-com days and the 2008 debacle rightly would be concerned.
Trouble is, we want the markets to go higher. It’s how your retirement portfolio grows, after all. Some of it is income from dividends and bonds, but a lot of the gains we expect from the markets come from plain old appreciation — higher stock prices.
That can feel like thin ice after a few years. We don’t want a stiff correction, and much less a bear market — or do we? After all, if you’re going to be buying stocks for years to come, lower prices are more attractive than higher prices.
A lot of advisors attack this problem with specific strategies meant to assure investors that they are “safe” from a market downturn. Here are a few of those strategies, in broad terms:
Flight to quality — After a few years of taking speculative positions in thinly traded shares, advisors wary of a crash might tell you to start buying more blue-chip stocks. They’ll go down, of course, but presumably less so than some of the riskier bets.
Macro events — Civil war, currency crashes, ebola…the financial news is full of sobering global headlines. They might affect your investments indirectly, or they might be the fuse that sets off a general retreat from risk. Advisors sometimes suggest specific shorting ideas to get ready for the worst, should it appear.
Value investing — When stock indexes go up, that doesn’t mean all stocks rise in tandem by the same ratio. Very good companies can get beaten down by factors beyond their control, or just investor ignorance. Some advisors specialize in buying just those firms whose prices they deem “in error” relative to their real value.
Building cash — You’ll hear this a lot from billionaires and their advisors, particularly on financial cable TV. This doesn’t mean they are selling, necessarily. Just not investing at the moment. Big portfolios generate a lot of cash all the time in the form of dividends and maturing bonds. They’re sitting on that cash for now, or so they claim.
Should you consider any of these strategies for a “bad but good” market that seems to inevitably rise? Of course not, and here’s why: Research has shown that, time and time again, these kinds of short-run strategies work for a while, then the market erases the advantages they might have offered.
Getting it wrong
One or two in 10 advisors might “guess right” on some breaking news event, and they look amazingly prescient in retrospect. You don’t really hear about the other eight advisors who got it wrong, or the 20 times that the currently “accurate” advisor got it wrong in the past. Same problem with value investing, shorting and market timing.
The more effective response to fears of an expensive market is to reconsider your own tolerance for risk. If you are in your 20s or 30s and have decades ahead to invest, be heavy in stocks. Any near-term losses will be made up, and you get to buy more, cheaper in the meantime.
If you are nearing retirement, you probably shouldn’t be heavily invested in stocks in any market. Unless you know you will have retirement income from a pension and Social Security that covers your cost of living, your portfolio likely shouldn’t look anything like that of a 20-year-old.
It’s common sense, I know, but the appropriate way to invest is according to your own, personal time horizon, not unpredictable stock market events.
If there was any other way to manage those risks reliably, that’s exactly what your advisor would do for you. Pretending otherwise is just irresponsible.
I was fascinated to read a recent piece about Boeing employees. For reasons known only to them, tens of thousands of the aircraft maker’s workers opted out of a free job benefit worth $98 million.
Not $98 million in sick days or cafeteria danishes but $98 million in cash, real money that they clearly wouldn’t reject if it were offered to them as paper bills in an envelope. Put another way, as Paul Merriman points out, it’s the equivalent of rejecting a 6% raise.
How did this happen? They failed to save money into their 401(k) plans or didn’t put in enough to get the maximum in matching funds from Boeing. Presumably, the matching money went to shareholders instead.
While horrifying enough, there are lots of ways we manage to avoid free money for retirement. Not all companies offer matching funds, and not all employers even have 401(k) plans, but anyone and everyone could save more and keep more of their hard-won earnings.
Here are five ways you can pick up free money for retirement:
1. Max your 401(k): This is the mistake of the Boeing workers. Not taking at least enough to get your company match is leaving money on the table every year. But you should seek to maximize your contribution. Taxes are progressive, so tax rates are higher as you earn more. Cutting your paycheck down by saving neatly cuts the portion on which you pay the highest possible tax rate.
2. Open a spousal IRA: If you are married and your spouse is a homemaker or has no access to a 401(k), you can set aside money each year into his or her account in a spousal IRA. It will cut your taxes as a couple, making the extra saving easier to do.
3. Do a Roth IRA analysis: Taxes you pay now are one thing, but taxes in the future matter, too. It’s a good idea to calculate the cost of converting past IRA savings to a Roth IRA. Likewise, you should max out your Roth contributions each and every year. Money you set aside is taxed now but grows tax-free after that.
4. Consider a health savings account: In a high-deductible health plan? Consider opening a health savings account (HSA) if your plan will allow it. You get to put aside money pre-tax you would spend on health care anyway (billed services, not premiums), and if you don’t spend it the money rolls over each year while earning interest. For high-income folks, it’s like having a second IRA.
5. Slash investment costs: This is huge. You probably pay a lot in mutual fund costs. What’s a lot? The average investor pays somewhere in the area of 1.5% for money management, and some 401(k) plans cost even more. Use index funds wherever you can and self-direct your IRA investments instead. Prudently managed, your money will grow faster as a result.
Nobody should leave free money on the table when it comes to retirement. That cash can and should be growing and compounding on your behalf. Failing to put it to to work will cost you later on, when your career days are done.
Put these five ideas on your “to-do” list for this year. Set a goal to tackle one a month if that helps you get it done. Just don’t leave it for later like the Boeing folks did. You deserve a good retirement.
If you ask working folks when they expect to retire, the typical answer for most is “65, I think.” Pressed, they might say “70, I hope.”
The fact is they don’t know, and that’s not a disaster so much as it is a sign that they haven’t done the math on their own savings and retirement planning. If you haven’t, it’s probably because the very idea combines two things most people prefer to avoid: math and their own mortality.
Time to get over it. It’s important to set a retirement age because if you don’t, you have no idea if you are saving enough to ever stop working.
Here’s an easy way to pick a retirement age, or at least start a conversation about it with your significant other. What year do you think your life will substantially change in terms of spending needs?
It’s a tricky question: If you have kids, it might be when they graduate or leave home. If you don’t, it might be when you own your home free and clear. For someone else, it might be when an inheritance comes due.
Asking the question that way puts a fine point on the issue: You might be substantially less beholden to a high fixed cost of living sooner than 65. If that’s the case, do the math backward to your current age to come up with the number of years you must continue to work at your current income.
Let’s say the number turns out to be 15. But you’re only 45 now. That means 60 is not an unreasonable retirement age. Can you estimate what your cost of living will be post-mortgage, post-kids and perhaps after having downsized?
Chances are, the number you end up with is somewhat lower than you might have guessed. Now, go to the Social Security Administration and calculate your expected income from government benefits at your earliest and latest possible retirement ages.
Now you know what it is likely to cost you to live in retirement and how much will be covered by Social Security. Fidelity Investments makes this a bit easier with a savings checkup table that can help you see if you are on track. Here’s an example:
Bob, age 45, has $250,000 in IRA and 401(k) savings.
Bob and his wife both earn an income, which combined total $85,000. Fidelity figures they’ll need three times that salary number to retire at 67. He’s pretty much on track, since three times $85,000 is just a bit more than he has set aside today.
Bob and his wife are projected to earn $32,000 a year in Social Security benefits, combined. Fidelity includes a rough estimate of that number in their rule-of-thumb math.
Make it happen
Here’s the kicker: Fidelity assumes that you need 85% of your income to retire, and that you don’t increase your savings rate by much.
It might be that neither are true. You might be able to live perfectly well on 60% of that income. Conversely, you might be able to double up on saving and push your target retirement year to lower than 67.
Don’t just say “65 or 70″ and hope for the best. Sit down and figure out your real retirement age target and, if necessary, kick up your savings rate a notch to make it happen.
Get two financial advisors talking at a bar, and pretty soon you’ll be breaking out a dictionary to keep up. The mathematics behind portfolio management would challenge even the wonkiest economist.
Yet a fundamental idea in retirement investing is easy to illustrate and important for the do-it-yourself investor to understand: risk-adjusted return.
Picture yourself standing on a basketball court. There’s a minute left on the clock and your team is down by two points. The ball comes your way.
You look down and realize that your feet are on the outside of the three-point line. If sink a shot now, there’s nearly a full minute still on the clock. In theory, you’ve just won the game, but the other team might quickly recover. All they would need to do is put the ball back down court and manage a layup and they win.
You also might miss that three-point shot and put your team into a world of hurt. There’s no guarantee your teammates will get the rebound and score a two-pointer to put the game into overtime.
The safer route is to drive in to the basket and get that two-point shot and force the game into overtime. A third option, and the riskiest move by far, is to wind down the clock to, say, 20 seconds and then take the three-point shot. Now you have to sink it, or all is lost.
Risk measurements come in various flavors and Greek-letter nicknames: alpha, beta, r-squared, standard deviation and the Sharpe ratio.
For our purposes, it’s simpler to consider the basketball game example, that is, if you have three investment choices — one that is relatively safe and keeps you in the game and two others that might pay off or might kill you — which do you choose?
For the long-term retirement investor, it’s always the safest investment that keeps you in the game and playing on. If you target a return of, say, 9%, then you want the investment mix that gets you to 9% on an annualized basis with the least amount of risk.
An investment might come along that promises 12%. It looks attractive and would compound your money a bit faster. But how much risk will you take to get that extra 3% in gains?
Ignore the clock
If the answer is “not much,” it’s a no-brainer. Buy the investment. However, if your analysis reveals that you would double or triple your risk of a major loss, the decision is easier. Take the safe investment that keeps you in the game.
Major short-term losses, even on paper, trigger all kinds of dangerous emotions. Facing a market going against your positions, it is too easy to take even bigger risks to compensate.
In essence, you’ve wound down the clock and you have to sink the three-pointer or lose the game. It’s a horrible place to be as a retirement investor.
A balanced, diversified portfolio keeps you in the game in all markets, irrespective of the clock. Not only will you get the gains you need, but you will live to tell the tale.
When you were growing up you probably played with a toy called the Magic 8-Ball. An oversized plastic billiard ball with a window at the bottom, it was a triumph of marketing if nothing else.
It worked like this: You asked a question out loud, any question, and then flipped the toy over. A triangle-shaped die inside a hazy liquid would float toward the window and provide one of 20 possible answers.
Ten were positive, along the lines of “Yes, definitely” or “Outlook good.” Five were wishy-washy replies, such as “Ask again later.” Five were negative or leaning that way, such as “Don’t count on it” or “My sources say no.”
If you spun the ball around long enough, chances were pretty good you’d get a positive answer or, at least, not an outright “no.” You had a better shot at good news than coin-flipping or some other purely random decision process.
When the markets are wobbly, which they are from time to time, we are tempted to take action, to “do something” to protect our money. It’s only human.
But consider what you are doing when you make that choice to sell in reaction to a decline. You are taking your money out of the market. In doing so, you incur a new risk, one which cannot be discounted.
Namely, stocks might instead rise. It’s extremely hard to say which direction your investments might take at any given moment, but it’s equally difficult to ignore the possibility that you have it exactly wrong.
What’s more, as prices fall, we tend to delay buying. Again, an assumption is made that the value of the potential investment will continue to fall.
The important idea to grasp is that when the media or your broker or your in-law (and, frankly, three out of four professional stock pickers) predicts that the market will crash, he or she is in no better a position to guess the near-term outcome than a Magic 8-ball.
In fact, you are likely to hear that person couch their predictions in similar language: “My sources tell me” or “the outlook is not good” or perhaps “this month (fill in the blank) is always a risky month for stocks.”
If markets fall, they look brilliant. If they don’t, it’s hard to pin down such a response as clearly a “yes” or a “no.” They have Magic 8-Ball immunity.
Coulda, shoulda, woulda
The far easier and calmer way to invest for retirement is to decide first what your exposure will be to stocks vs. bonds and other, less volatile investments and then stick to it.
If prices fall, buy more. If they fall again, continue to buy. You’ll find that as prices decline your dollar goes further, an effect known as dollar-cost averaging. You get more shares.
Most importantly, you will be in the habit of ignoring short-term ups and down and the impulse to time the market. Buying in all markets — up to your pre-set limit for each investment type — keeps you from sitting out markets that could easily rise and give you unexpected gains.
Your market-timing friends all have stories of “coulda, shoulda, woulda,” times they sat in cash and watched the market roar higher. What they tend to forget is that those gains, smartly rebalanced, would have compounded for them into the future.
A fundamental obstacle for many retirement investors is understanding the difference between an investment and an asset class, and how owning an index fund relates.
Why own an index fund? Because it gives you exposure to an asset class. It might be a stock index fund, a bond index fund or even a real estate or commodities fund, but all of them work the same way: Rather than pick single investments you own them all.
“All” in this sense means every investment in a given index. So, if you own an S&P 500 Index fund, that fund in fact owns all 500 underlying stocks in the index. A bond fund might own 5,000 different bonds. You have an investment that is an asset class, or close to it.
There are very narrow specialty funds, too, but for the purposes of a retirement portfolio most are too volatile to consider. What you want is exposure to the broadest, most liquid, most stable investments that exist in any given asset class, and that’s all.
Besides diversification, you get to own that exposure at a very, very low price. For instance, a typical active mutual fund that purports to follow large-cap stocks is by design picking some of them and ignoring others.
The proposition is that the manager of that active fund knows which large-cap stocks to own now and which to avoid. They might be focused on value (buy stocks that are out of favor) or growth (buying stocks likely to rise in the medium term) but they all operate on the basic idea that the managers have an inside track that the market does not.
And they might. But most often they do not. They trade in and out of positions all through the year, trying to catch updrafts and avoid declines, but in the end most active managers struggle to replicate the market return for their investment type.
Once you subtract their management fees, they fall even farther behind. If you own the fund in a taxable account, it’s even worse. And your fellow investors might lose faith in those managers and sell off, or simply choose to move money elsewhere.
Risk and reward
The risks are bigger than they seem, while the reward — consistently beating the stock market — turns out to be maddeningly elusive. Every year you don’t pick up the low-cost gains available from a straight index fund is a year lost, forever.
And that’s the salient point: Time is money. You really can’t fool around with a mediocre manager for five or seven years hoping that he or she beats the market once or twice. Subpar returns all of the rest of those years will hurt you, a lot.
It will hurt because you have blown a chance to compound your money, and compounding is how retirements happen. Not flash-in-the-pan stock picks or exciting macroeconomic calls. Just steady, reliable growth, building up over decades.
The U.S. government recently issued guidelines for the ownership of annuities in 401(k) plans, patching what had been a big hole in many workplace retirement offerings: How to secure an income after you stop working.
The thinking is that many American workers have no idea how to invest for their goals and even less how to invest for income with success. So, for the first part plans moved toward target-date funds and now, with annuities, they can start to address the second.
Efforts to make American retirements more predictable and secure are welcome. However, one should be very careful with any product that offers to solve all your problems in a single decision. The reason is fees.
Some target-date plans, for instance, are extremely cheap and effective. Others lard in fees that are sure to drag down your long-term results. Likewise, certain types of annuities can be cost-effective and useful. Many, however, are sold mostly because they pay fat commissions to the advisors who sell them.
You can invest smartly for income in retirement — if you understand asset allocation. While annuities offer guarantees, you have to remember that the risks you face in retirement go beyond just outliving your money.
An annuity is best thought of as an insurance contract. The annuity seller invests your cash and takes the risk that the market might not perform and that you might live longer than the actuarial tables indicate.
To account for those risks, the “guaranteed” return has to be lower than the market might otherwise provide, and there has to be room in the incoming investment flow to pay the managers.
If you instead own a portfolio and manage it for income, you don’t pay those management fees, just very low index fund fees. From there, what matters is estimating your years in retirement and working backward.
If you think it might be 30 years, go ahead assume a bit longer. A good retirement income asset allocation will provide current income but also hold some stocks in order to offset the effects of inflation.
See, stocks are inflation fighters, have been for decades. While your holdings of shares might be lower than when you worked and needed to grow the principal, your need to grow that pot doesn’t diminish completely.
As you age and start looking down the road toward the end of your plan, you can reduce that exposure and increase your income-producing holdings accordingly. But it will probably never be zero.
Building a low-cost, appropriately risked retirement asset allocation is not that hard to do. Done right, it can provide you with years of low-cost, reliable income.