As with most other complicated topics, retirement investing comes with a set of overly simplified, generally accepted rules, many of which are wrong at best, disastrous to your portfolio at worst.
Adapted from a recent ThinkAdvisor article (and expanded upon), here are some of the more common (and erroneous) beliefs about retirement investing:
- You have to get to your “number.” It’s easy to understand how this idea is so prevalent. A very effective television ad from a couple of years ago shows people walking around literally carrying a dollar figure, and a voice-over asks “Do you know your number?” The ad suggests you can calculate to the dollar how much you will need to live out your entire retirement and not outlive your money.
And it’s true – you can calculate that number. All you need to know is your exact retirement date, exactly how much you will spend throughout your entire retirement, the exact amount of income you will get from other sources (such as social security), the exact amount of gains you’ll get from your investments, the exact amount of other expenses, fees and taxes you’ll pay over the rest of your life, and of course, the exact day you will die. And none of those variables can EVER change between now and the end of your life.
But since none of us know for certain ANY of those things, we need a better approach for maximizing the odds of a successful retirement. Focusing on withdrawal rates and cash flows makes more sense to me, as it leaves room to make adjustments if you find yourself either over or underspending in retirement.
- You should live off of earnings and never invade principal. Another simple concept – as long as you limit your income to what your account earns, you will never run out of money. Three problems:
#1) To the extent you are invested in stocks, you can’t be sure how much income you’ll get, or if you’ll have any income at all. You could always have losses, sometimes significant ones. So if losses are to be avoided, you can’t invest in stocks at all, which leads us to:
#2) While bond investing can do a better job of keeping your account balance out of the red, future returns are also unpredictable, and the further they fall, the less you will have to spend. But that’s really a moot point because of:
#3) Inflation. Virtually everything you buy next year is going to be more expensive. So fixing your income while everything you need is getting more and more expensive just makes no sense.
When you think about it, it is difficult for those first two beliefs to co-exist. If you determine your “number,” it must be based on the expected return you will get from your portfolio. But the number will have to change if that expected return changes. Bond return volatility gives us an easy way to demonstrate that:
If you need to take $50,000 per year from your investments, and if bonds are paying 5%, what’s your number? Simple math: It’s $1 million. 5% of that is $50,000. So retire with $1 million, buy a bunch of 5% bonds, collect the interest and retire happily ever after. Right?
Maybe. But probably not. What if, by the time your bonds mature, interest rates in similar bonds have fallen to 3%? If you reinvest your $1 million in new 3% bonds, your income falls to $30,000. The only way to get back to $50,000 is to invest in riskier assets, or to increase your number to $1,666,667. How are you going to do that if you’re already in retirement? I suggest you practice saying this: “Welcome to Walmart. Can I help you?”
- A retirement portfolio is loaded with blue chip stocks and income-producing bonds. This one is as old as, well, any of us. It goes back to the Depression era or maybe further. It came from the idea of taking risks during your working years to build your nest egg, then shifting to something relatively risk-free for your retirement.
So what’s the problem with that? There isn’t one. There are a bunch of problems, mostly because the investment and retirement landscapes aren’t even close to what they were 80 years ago.
First off, retirements are much longer. In the 1930’s if you lived to age 65, you could expect a retirement of about 7 years. Nowadays it’s pushing close to 30 years. With a 7 year investment horizon, you should be very conservatively invested because you may not get through a single large or long market downturn. But with a 30-year time horizon, you either need a much larger nest egg or you need to be a little more aggressive to earn enough in your account to last that long. And this is where inflation really makes an impact… over a decades-long retirement.
Another problem is that what was once risk-free isn’t so risk-free anymore. What would a safe blue chip stock be? For decades, it was GM. “What’s good for General Motors is good for the USA,” the old saying went. And a few years ago, GM went. To a value of $0 that is. If the Great Recession taught us anything, any company can fail.
Even bonds can’t be considered risk-free any more. With municipal defaults and agency defaults such as Ginnie Mae, diversification into riskier asset classes can actually make your portfolio less risky. True story.
And one final change in the investing landscape since the 1930’s is the tax code. The dividends and interest that retirees have been taught they should live on are taxed at an unfavorable rate compared to long term capital gains, so it is smart to build a portfolio designed to generate capital gains, not interest and dividends.
Source: 3 Myths of Retirement Investing ©2015 ThinkAdvisor