10 Myths of Retirement Planning
There are a number of issues and events to consider when it comes to planning for your retirement, especially if that anticipated retirement date is many years in the future. While your financial future cannot be predicted there are some commonly held myths that we can dismiss to potentially help make your planning efforts less intimidating. Here are some retirement myths to look out for.
- Once I contribute money to my retirement plan, I’ll never pay another tax on it. This is false. While most qualified retirement plans have tax advantages, it’s usually in the growth accumulation phase only. Retirement accounts, including 401k, 403b, IRA, SEP IRA, and profit sharing accounts accumulate their balance on a tax deferred basis but the tax benefits end there. Unlike Roth retirement accounts, which accumulate and distribute balances on a tax free basis, subject to certain holding rules, virtually all other retirement plans make distributions to the recipient that is fully taxable as ordinary income.
- A Roth IRA is the best place to invest for retirement. Possibly. A Roth IRA is funded with after tax money—from your checking account, not a payroll deduction. While it’s true that a Roth IRA is structured so that the balance appreciates tax free and qualified distributions in retirement are tax free, these benefits come with an important footnote. Current laws preclude some investors from contributing to a Roth IRA if their income exceeds certain levels. For 2014, a married couple may fully contribute to a Roth IRA if the household income is less than $181,000, ($114,000 for a singles). The bigger issue is not whether one qualifies, but the cap on your potential contribution. Under age 50, the maximum amount that can be contributed is $ 5500 or $ 6500 for those over 50. A better choice, if available is a Roth 401k which has no income restrictions for eligibility.
- I qualify for a Roth IRA and that’s all I need for retirement. Not true. If in fact you qualify for a Roth, even the maximum amount that can be contributed in any single year is far below the threshold necessary to accumulate enough assets to carry you through your retirement years which may last upwards of 25 years or longer. Assuming someone contributes to a Roth for 25 years, starting at age 40, with a sample growth rate of 5% each year, their total accumulated value would be approximately $320,000. (Note this figure assumes no market declines for 25 years which is statistically unlikely but used simply as an example). If we generate a 4% withdrawal, the approximate income would be $1060 per month. Though this income is tax free, it’s likely insufficient for the average person to live on.
- A 401(k) is the best place to invest for retirement. It can be a good place to have some of your retirement money but it’s hardly the place to house all your retirement money. Many 401k plans are laden with various built-in platform fees. Added to the internal operating expenses of some of the underlying fund choices and the overall expenses for some savers can approach 3% – 4% per year, or more. Another important issue is that many company 401k plans only offer a limited number of investment options. While some plans offer a generous menu of fund choices, they may still lack the flexibility to allow employees to invest in a specific company stock, alternative investments or other funds not offered in the plan. Some companies still offer less than a handful of choices to their employees, severely limiting their potential growth. Yet, 401(k) plans can offer the employee some terrific tax advantages and a seamless way to invest for retirement, especially if they’re not doing anything else. It’s usually wise to contribute enough to receive matching contributions from the company. Finally, keep in mind the government offers you a tax break today in hopes of your having a larger balance to tax in the future.
- You need a lot of money to have a large retirement income. It helps, but is not absolutely required. A few strong habits could be more helpful. First, contributions to your retirement account should be made consistently, such as monthly or quarterly. Over time, you will contribute when assets prices are both low and high and will ultimately smooth out or average cost your account. Another important aspect during this accumulation phase is to avoid frequent and/or substantial losses, if possible. The law of numbers says that the percent gain necessary to make back a loss is always larger than the original loss. For instance, an account that loses 20% now requires a 25% gain to get back to breakeven. Those investors who lost 40% of their balance in 2008 needed a 66% return to get back to even. Making up a loss means that future opportunities to gain are severely handicapped. This is known as opportunity cost—while you were making back the loss you could have been generating a positive return during the same time period.
- Invest solely for growth—over time, you’ll always make money. Not true. There’s a reason that printed on all investment brochures and prospectuses, the words “past performance does not guarantee future returns”. Strong returns can be found but there is no way to predict them nor any way to use a prior year as justification for what might happen in the future. Time helps but is no guarantee.
- Your money is safer if you don’t invest and keep your money in a bank. This also is not true. Just as number 6 above said you cannot predict market returns, does not automatically mean that a retirement investor should completely exclude and avoid equity based investing. Just as prior gains do not guarantee any future gain, the same is true for prior market losses.
- I can retire on my Social Security benefits. More than likely, no. The Social Security program, which began in the 1930’s during the height of the depression, was never originally designed to support someone for the full span of their retirement. It was specifically set up to offer a supplement to one’s pension or other form of retirement savings. The solvency and longevity of the Social Security program is a subject of hot debate. Still, it’s a good idea to log onto the program’s site to review your own specific benefits. That site can be found at www.SSA.gov.
- My future retirement income can be easily computed by expecting a future balance and multiplying some interest rate and that’s my monthly income. No. This rationale may lead you to severe retirement shortages and believing this can be financially perilous. Many investors forget about the twin thieves to their retirement balances, and hence, their ultimate retirement income. The first is market volatility. As said, what occurred in the past has little to do with what may occur in the future. Gains may be followed by additional gains or a loss that completely wipes out the gains for an entire year or several years. Many people who planned to retire in 2008 or 2009 were unpleasantly surprised at the level of principal erosion in their retirement accounts. Plans made years prior were completely turned upside down as investors struggled to first comprehend and then try to repair the utter destruction their accounts had suffered. Growth is a double edged sword—you recognize the need to allocate some portion of your retirement plan to equity growth, but simultaneously know that the potential for a roller coaster ride is always there. There is no way to assume a ‘given’ rate of return for the market or for your market based retirement account and then extrapolate going forward. The 40% loss that some investors saw in 2008 is itself a follow up to a combined 40% loss that occurred during the tech bubble of 2000-2002. The second thief to your retirement account is taxes, plain and simple. Distributions from all qualified retirement accounts, other than Roth accounts, are taxable as ordinary income. There is considerable debate as to what tax rates may be in the future but the issue remains that retirement investors are likely to endure a substantial reduction in net income. In retirement, many investors may find themselves in a higher tax bracket than previously envisioned. Why? Tax rates may go higher to help cover the Federal Deficit. Also once the mortgage is paid off, some tax deductions may be eliminated. Finally, if your children are older and have moved out of the house, they may no longer be declared as dependents. Check with your CPA.
- If I have one or more retirement accounts, I have a full retirement plan. This can be readily dismissed as complete nonsense. The truth of the matter is that most people plan their summer vacation with more attention and devotion than they do to their retirement plan and retirement income plan. You would laugh if someone said they are going on vacation and will decide on their destination once they get to the airport. Yet, retirement is, in some respects, a 25 year vacation. Multiple accounts do not automatically equal a prudent retirement plan.
Market volatility and unpredictability can wreak havoc on your retirement your plan. A substantial market loss can occur during a multi-year decline or worse, during a single year. In both cases, the results are extremely detrimental to your retirement growth.
If it’s possible that future market volatility and uncertainty, coupled with ordinary income tax levels will persist going forward, it’s is also possible that some long held beliefs about traditional retirement income planning are faulty. If your pilot is fueling the plane from JFK to LA, do you want him to put in just enough fuel or more than enough? Just enough may get you to LA safely, but what if the pilot encounters turbulence and other weather or mechanical issues? Similarly, do you want to plan your 20 or 30 year retirement with just enough income or more than enough? Most would opt for the latter. If you do, what exactly is your plan? Can you clearly articulate to your spouse or friend exactly what that plan entails and what your strategy is to deal with market volatility and taxes?
If not, you don’t have a retirement plan.
Some potential risks to your secure retirement
Several risk forecasts can help determine whether a retirement plan is sound and will be successful. Each of these must carefully be analyzed and weighed as potential dangers to a secure retirement strategy. Whether you are retired, soon to be retired or still working full time and not planning to retire for many years, a retirement blueprint should be created to help ensure that the inevitable bumps in the road to retirement and thereafter do not derail your long term security.
Longevity risk refers to the possibility you could outlive your money…by many years. Remember that an average life expectancy is just that – an average. Many people in their 60’s or 70’s still have one or both parents living, which can be an indicator of their own longevity potential. Living past 90 or even 100 is more common than ever. What are you doing to help ensure you don’t outlive your income?
Market risk can also be called volatility risk. Few people look for investments opportunities that will lose most or all of its value. Instead, risk can arise from investing in something that is currently near peak value, only to drop substantially later on. The important issue here is that large market declines during the early years of your retirement can and will have a detrimental impact on your ability to withdraw income in later years. What are you doing to help mitigate or eliminate market risk to some of your retirement assets?
Health Care Risk
As people live longer, there is the likelihood of an increased need for medical care on a more frequent basis. Further, Medicare coverage limitations ensure that retirees will now shoulder more of these unknown expenses than ever. According to the Bureau of Labor Statistics medical costs have increased at double the rate than inflation. How have you planned for this eventuality?
Tax and Inflation Risk
T & I risk falls into the stealth risk category. We know it’s out there, but we may not be conscious of it on a daily basis. The combined impact can severely reduce purchasing powers and leave you with significantly less spend-able dollars. Many investors have not adequately considered whether taxes will be the same or higher during their long retirement. While some believe they will be in a lower tax bracket, that outcome may actually not be the least bit comforting. A 3% inflation rate causes prices to essentially double in twenty four years, and at 4%, it only takes eighteen years to double costs. What steps have you taken to reduce or eliminate taxes during retirement?
Long-Term Care Risk
Long term care expenses, not covered by Medicare, can wreak havoc on a retirement plan. Though many people prefer to self-insure, the costs associated with LTC, not covered by insurance, can decimate a sound and carefully planned retirement strategy. Have you analyzed what the cost of LTC coverage is against what it might cost to pay out of pocket?
There is much debate as to the wisdom of adhering to a fixed withdrawal rate from your pool of assets. Conventional thinking had pegged that figure at approximately 4%. However, recently, it has suggested this figure may be untenable if that asset pool suffers even modest valuation declines in the early years of retirement and/or suffers additional declines in later years. The resulting valuation may not support distribution levels once thought inviolable. Consequently, retirees may find themselves with not only a smaller principal balance, but an ever spiraling need to reach for higher yields, potentially putting some of their remaining assets at even greater risk. Reducing the distribution rate means retirees now have to manage to live on less income. When was the last time you stress-tested your retirement income plan?
Maturity and Reinvestment Risk
There exists a real possibility that when your high interest bonds or other fixed income investments mature, options to secure the same or higher yield will not be available. Bonds may be called earlier than the stated maturity date and income oriented investments can and do mature with regularity. Replacement yields can often be much lower forcing investors to cope with reduced investment income or potentially accepting a lower quality rated vehicle, which is certainly not the favored approach in or near retirement. What’s your plan to maintain consistent retirement income?
Unexpected and Unknown Risk
It is quite possible that grown children may move back home when job or personal issues arise. Or, a family member may require substantial financial assistance to cover student loans or a down payment on a home. Have you had a candid discussion with your children regarding their finances as well as yours?
Remaining Thoughts: Have you left the planning and monitoring of your retirement strategy to a web site and pie chart? When was the last time you ran your plan through lifeboat drills?