There is one day among all others that it is the riskiest day of your financial life. The day that you retire. Let me explain. There are two main risks when it comes to investing. First, the most obvious risk is volatility. The chance of loss that can occur, especially when you invest in risky assets like stocks. The second risk is inflation, or the potential for outliving your money. If the costs of goods and services go up faster than your investment portfolio this becomes a real risk. These two risks are elevated the day your retire. If you experience a major loss in your portfolio in the first year of retirement, you are going to have to maintain your lifestyle on a much lower asset base for the next 25+ years. Similarly, if inflation explodes higher right after you retire, you will need to generate more income for your entire retirement just to maintain your current standard of living.
To look at it another way, if you are 90 years old, both volatility and inflation aren't as large of a threat. You just aren't going to live that long for those risks to do significant damage. If I am 92 years old, have $1 million, and am pulling $50,000 per year from the portfolio, it really doesn't matter that much if I lose 30% of the portfolio value, I still have 14 years of income ($700,000 portfolio divided by $50,000 per year) left if the portfolio has no growth from that point on. These risks subside every day as your life expectancy gets shorter.
At retirement, there are some ways to mitigate those risks:
- Volatility- there are two ways to counteract volatility. The first, and easiest. Invest in safe assets. If you just buy CDs with your money you won't experience any volatility (unfortunately you won't earn much either). Another way to reduce volatility is to extend your holding period. Over rolling one year periods, stocks lose value about 30% of the time. Over rolling ten year periods, they only lose value about 5% of the time (S&P 500). That is why volatility is not a major risk to younger investors. If they don't sell, those losses tend to recover, because they have lots of time before they need their money.
- Inflation- while we haven't seen any significant inflation in our country since the 1970s and early 1980s, it would be wise not to disregard this risk. One of the best ways to fight inflation are with assets that benefit from rising prices. Mainly, stocks have been able to incorporate rising inflation into the prices of the products they sell and real estate increases rent and sees values go up. More recently, the US government has created inflation protected securities which increase in value directly with the consumer price index. In short, there are specific securities that can help combat an inflationary environment.
Thinking about these risks and how to mitigate them in retirement is key to a successful retirement income strategy. Now that pensions have become less common, and interest on CDs and bonds are meager, it is more important than ever to have a solid strategy in place.
Schwab Retirement Plan Services recently announced the results of a nationwide survey of 401k participants. When it comes to getting professional 401k advice only a small percentage of participants actually got help even though most people acknowledged their need for such advice and the confidence that would come from it. Participants were much more likely to get help for the following things:
- 87% – Changing their oil
- 51% – Installing a new faucet
- 36% – Preparing their taxes
- 32% – Getting help landscaping
- 24% – Getting help making 401k investment decisions
Clearly, this is more evidence that we have an engagement problem when it comes to getting most people to save and invest wisely for retirement, even though people recognize the need to do so and the peace of mind that comes from with it.
Schwab has put together a really nice infographic that summarizes the results in more detail: Schwab 401k Survey Infographic
What makes a good 401k plan? Last week I offered my perspective on the challenges I see with President Obama’s myRA retirement plan initiative. Today I’ll share my opinion on how companies can design a 401k plan for participants the right way. From a participant’s standpoint, there are only four variables that go into the “retirement savings equation” – what goes into your account (contributions by you and your company), what comes out (fees, loans and distributions), what rate of return you achieve and time. If people are going to retire successfully it’s going to require a combination of sacrifice and an aggressive partnership between workers and companies which I think should include:
- Aggressive automatic enrollment (at least 6%) – studies show that opt-out rates are not strongly impacted by the default percentage so it makes sense to be aggressive – your employees will thank you later
- Aggressive auto escalation (at least 2% per year) – most participants keep their contribution at the default instead of incrementally increasing over time – people need to save more
- Diversified, Low Cost Portfolios – The vast majority of employees will be far better off over time by being invested in a well-diversified, low cost portfolio (with exposure to riskier asset classes like stocks) that is managed for them – plus, a 2-3% return is not going to be enough over time
- Low Fees – Participants should pay no more than 1% in total plan fees (and ideally less than .50%) – to achieve this companies generally need to pay more of the plan’s administrative fees directly
- Company Generosity – Studies show that employees need to save at least 10% per year and in many cases that number may be closer to 15-20%. I believe companies (including my own) have a moral obligation to help their people retire successfully and a 3-4% company contribution just isn’t going to get them there. Companies need to begin to view retirement contributions as not just an expense but an investment in their people and their business
- Time – Accumulating sufficient retirement assets does not happen over night, it takes a long time, which means employees need to start saving as early as possible
Earlier this week, President Obama directed the Department of Treasury to create a new, government-back retirement account dubbed “myRA”. It aims to help lower income Americans begin saving for retirement who are not covered by a plan at work. So the question is “will it work” or is the concept of “myRA” simply a nice talking point to include in a political speech? From my perspective, the answers are no and yes, although I definitely agree with the President that we need to help all Americans save more so they can retire successfully. Here’s a brief overview of how a myRA will work:
- Employers can setup these accounts without cost and don’t have to contribute to them
- The account will basically work like a Roth IRA – money goes in after-tax and can be withdrawn tax-free in retirement
- Like a Roth-IRA, contributions can be made up to $5,500 annually and the same tax/penalty rules apply
- The accounts will be solely invested in government savings bonds (paying historically low yields) and are principal protected (meaning they cannot lose value)
- The accounts are portable meaning they can be kept when switching jobs
- There are no administrative fees
- Once an account reaches $15,000 or is open for 30 years it gets converted into a Roth IRA
- Initial investments can be as low as $25 and as little as $5 for subsequent contributions
Sounds nice, but will it work? In my opinion, there are a number of issues, namely that the types of people these accounts target (lower income and part-timers) simply don’t make enough money to save. With no automatic enrollment requirement and no required employer contribution what is the incentive to contribute? The issue these workers face is the same even when they are covered by a plan at work, even if the employer makes a matching contributing – they either don’t have the money to save or don’t join the plan because of inertia. The ONLY thing that can get these people to participate is automatic enrollment. Also, it’s ironic that a myRA basically flies in the face of the Pension Protection Act of 2006 (PPA). Under PPA, companies were encouraged to adopt automatic enrollment, automatic escalation and a “qualified default investment alternative” suitable for long-term retirement savings (such as a target date fund, balanced fund or managed account – but not a principal protected bond fund). The myRA approach includes none of these things.
I applaud the President for his intent with myRAs, but like many things (political and otherwise), the devil is in the details. Given the fact that these workers could simply open a Roth IRA do we really need another type of retirement account? While some companies may adopt these I fear the utilization rate will still remain very low.
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.