Planning for your eventual financial freedom – where you live off your assets rather than your income – is one of the crucial tasks that many investors undergo in their careers. While there is no “one size fits all” solution to retirement planning, there are some common mistakes that you should avoid along the way.
Investors, indeed, benefit from comprehensive advice around their retirement plan, but selecting the right advisor, who both understands and meets your needs, is vital in the development of a successful retirement plan. This guide was written to make you aware of the ten most common pitfalls that you should avoid when planning for your retirement, and how you can exponentially improve your retirement plan by seeking the right advice.
1. Avoid being too conservative
Due to the constant advancements in medicine and technology, the average life expectancy of an individual has grown significantly and will continue to do so in the years to come. Someone who retires today at the age of 60 may live another 20 to 30 years, or even longer. That’s a long time for your money to be growing at a low rate, as a result of allocating too much into traditionally lower risk investments, such as bonds, particularly given where the interest rates are today.
In the short term, bonds often have been considered less volatile than stocks, and while many investors tend to associate bonds with safety, you might be surprised to learn that over a longer time horizon — 30 years or more — stocks have shown lower volatility, as well as more uniform and higher returns than bonds. In the last century, stocks have outperformed bonds in every single 30-year-period. Cash and CDs are also conservative investments, but they might not meet your long-term needs given their low yields.
There are conservative investments that can provide that and, in fact, might also be the right decision for some investors, or for just a portion of their portfolio. We generally recommend that investors keep available any funds that they will need access to in the next 12 months either in cash or in a low risk bond allocation.
Bonds also pose risks. One is that their value can drop dramatically if interest rates go up. Bond prices and interest rates have an inverse relationship. As interest rates increase, the value of bonds decreases. For example, if you need access to your bond investments to pay for a wedding, help make a down payment on a home, deal with unanticipated home or medical expenses or if you simply just want access to your cash now, you could be faced with selling a bond below the price you initially paid for it. With interest rates near historic lows, most investors assume that rates will eventually go up, thus causing bond prices to fall.
It’s also common for retirees that worked at the same company for many years to accumulate a large amount of that company’s stock in their portfolios. Some choose not to diversify, because they feel that they know their company well and that this helps them to manage the equity exposure risk, but concentration is neither an effective nor conservative strategy. Most investors are still better served to diversify, and an advisor can help even more with strategies to manage the taxes around the sale of long held equity positions.
2. Avoid a strong home country bias
The United States is the world’s leading economy, and many of our largest companies are major global players. For example, multinational companies headquartered in the US often get a substantial portion of their revenue from sales outside the U.S.; but this isn’t the same as true international diversification. Any form of home country bias, regardless of your home country, could cause you to miss access to growth potential from other markets.
The strong performance of U.S. stocks in recent years has engendered some scepticism among U.S. investors when it comes to international investing. Nonetheless, it is important to remember that international investing can offer two important benefits: diversification and access to growth potential.
Historically speaking, the United States and other international stocks have gone through periods when one region outperformed the other. This was the case during the high volatility in December 2018, when emerging markets outperformed the US, this underscored the importance of having some exposure to stocks outside the US. Combining assets that don’t move in lockstep may help to reduce the volatility in your portfolio in the long run.
International economies – particularly emerging countries – can offer faster rates of economic growth than the U.S. For example, in emerging markets, a growing middle class and developing infrastructure may help generate wealth and dynamic companies with significant growth potential. Developed countries are already home to many world-class enterprises, that only U.S. investors could be missing in their portfolios.
Investing in international stocks involves risk, including currency exposures and geopolitical risks. One way to help manage this risk is with a “core/satellite” strategy. For example, you, the investor, could hold some broad exposure (core) to an asset class through an international fund, while enabling the flexibility to adjust to current market conditions with country-level investments (satellite). An advisor can help you determine how international diversification fits into your retirement income plan.
3. A dollar today won’t be the same dollar tomorrow
Inflation is one of the most important factors in the lifespan of an investor and his purchasing power. To put it simply, purchasing power means how much your money can buy, or its “buying power.” You lose purchasing power when prices go up, something inevitably that happens over time in most of the world’s countries because of the impact that inflation has over their economies.
Inflation is tracked through the Consumer Price Index (CPI), which measures the cost of a basket of 175 consumer goods and services — everything from food items, to healthcare and housing prices. Each month the U.S. Bureau of Labor Statistics (BLS) computes an average cost of these items to determine how much it has changed since the previous check in. This identifies how much inflation has been, and thus shows you the current purchasing power of your dollar.
It’s important to note that the basket of goods is seen as an average for households but might not reflect your individual consumption. For example, the overall CPI might only rise with 2% (which is the inflation target the country’s central bank, the Federal Reserve, uses to inform its policies). But some other items, such as the intercity bus fare and health insurance, recently rose by much more — 21.8% and 18.6%, respectively — while other costs, such as those of used cars and trucks, declined.
What does this mean for you? If you pay for your own health insurance and don’t buy a used car, then you might feel as though you have less purchasing power, since health insurance rose more sharply and makes up for a larger percentage of your personal budget. In addition, private education expenses have also risen at more than double the rate of the overall CPI, creating an unexpectedly large expense for parents and grandparents who are funding university or other private school costs for their children and grandchildren.
4. Avoid inessential costs
This isn’t about your spending habits, but rather about what you are actually paying to manage your retirement assets. Reducing investment expenses, which include sales loads, commissions, management fees, taxes, and insurance charges, holds potential to allow you to retire years earlier, and with an even far greater amount of money. Fees can cost you hundreds of thousands of dollars over your lifetime, and they impact you in two ways: first, the actual out-of-pocket expenses and charges; second, the money that you spend on fees is money that is not working for you. Over a lifetime of investing, and because of the power of compounding, this can become a very large number. Even seemingly small variances in fees can make a huge difference in the amount of money that you will end up with in the long-term.
The first step in managing your expenses is to select a fee-based advisor who does not take commissions from investment products, providing you with full disclosure on all your costs. It’s also critical that your financial advisor works hand-in-hand with your tax advisor as part of your overall financial planning, taking into consideration things like withholding tax, income tax, capital gains tax, and estate tax. Proper tax planning should be done annually and should include a review of current tax rules and brackets and an analysis of all your financial assets.
By recognizing the importance of costs, some attentive investors have decided to educate themselves better. With time and experience, the necessary knowledge and discipline is relatively easy to obtain. However, you may be much better off paying a fair price for pieces of comprehensive advice and disciplined investment managements, rather than risking to do them poorly by yourself. Of course, there are hybrid solutions that can reduce fees dramatically. These include enlisting the aid of a financial planner with the initial development and implementation of a plan and then maintaining it by yourself. You could also meet periodically with an hourly rate advisor for a second opinion and a sounding board on any changes to their plan.
Other costs to be wary of are fees for certain “guarantees”, including guaranteed income off an annuity, or a guaranteed rental yield off an investment property. The firm or person making the guarantee isn’t losing money in the transaction, and many of these guarantees are sold to take advantage of investors’ fears about uncertainty. You may be better served to have more certainty through a comprehensive plan, rather than paying someone to create it for you artificially.
5. Keep your budget on track
Whether your budget is $50,000 a year or $1,000,000 a year, carefully tracking and updating a budget is critical to financial success in retirement. This all translates into budgeting and it doesn’t have to be a dreaded task. Think of budgeting as a roadmap for your money. You’ll have more money available for the things you value most if you’ve accurately mapped out where it all goes. Don’t mistake this with the previous point of avoiding unnecessary costs, because it’s much harder to catch costs that you can’t see.
Budgets also contribute to harmony within families. Arguments sparked about spending, particularly within families, are inevitable. By setting out clear, pre-agreed guidelines on how people can spend money can help to prevent disagreements and stress. Just because you can spend freely doesn’t mean that you should, or that there aren’t negative consequences for being out of touch with your cash flows.
Once you have a budget, you should consider what you want to happen to the money you’ve accumulated. Here, you have four choices: spend it down, keep it at the current level, preserve its buying power by having its value keep up with inflation, or spend/invest it to grow as much as possible. Very few people want to spend their wealth to zero, and risk running out of funds during their lifetime.
6. Market timing is bad timing
Attempting to buy individual stocks or make tactical asset allocation changes at exactly the “right” time presents investors with substantial challenges. First and foremost, markets are fiercely competitive and adept at processing information. The combined effect of all this buying and selling is that available information, from economic data to investor preferences and so on, is quickly incorporated into market prices. Trying to time the market based on an article from this morning’s newspaper or a segment from financial television? That information is already reflected in prices by the time an investor can react to it.
Outguessing markets is more difficult than you might think. While favourable timing is theoretically possible, there isn’t much evidence that it can be done reliably, even by the most cunning and professional investors, not to mention that for the timing to work, you have to be right twice, making the odds of a positive outcome even lower. The positive news is that you don’t need to be able to time markets to have a good investment experience. Over time, capital markets have rewarded investors who have taken a long-term perspective and remained disciplined in the face of short-term noise. By focusing on things that you can control (such as having an appropriate asset allocation, diversification, and managing expenses, turnover, and taxes) you can better position yourself to make the most of what capital markets have to offer.
7. There’s more to focus on than just income
Even if you have accumulated a significant retirement fund, making the wrong withdrawals or assumptions around income could put your retirement at risk. Many investors focus too much on the actual income number (the interest or dividends they receive) rather than the total return. If you broaden your view of what your retirement income should look like, to include asset sales and spending parts of your principle, you’ll be more likely to have a comprehensive plan that will last throughout your retirement years.
Generating a retirement income requires you to balance a variety of elements, many of them beyond your control, such as inflation, stock-market volatility, interest-rate trends and you and your spouse’s expected longevity in years. If you’re too conservative in your investments, then you risk having inflation strip you of purchasing power; but on the other hand, if you are too aggressive, you risk losing your money. Take too much out early in your retirement, and you risk running out of money in your later years, but be too stingy with your withdrawals, and you might be cheating yourself out of the enjoyable experiences that your hard-earned money could enable.
All of the above are difficult and emotionally charged decisions and are the reasons why investors frequently make mistakes or act irrationally. If you consider the bigger picture, not just whether your yields dropped, or the market value of your investments went up or down, you can avoid some of the emotionally driven mistakes that investors, who are narrowly focused on income, make.
8. Not all debt is bad debt
Debt that creates opportunities can make financial sense for you, and many wealthy families use debt in smart ways for themselves, their real estate and their businesses, and even in retirement. For instance, with mortgages or home equity lines of credit, you’re borrowing to own a potentially appreciating asset, or avoid selling appreciated assets to buy real estate (which would trigger capital gains taxes and forgo the opportunity for further market appreciation). On top of that, home loans may be tax-deductible. Some mortgages and student loans also have very low rates, such that you can comfortably earn more in your investment portfolio than you pay in interest.
However, there’s nothing positive about debt that’s high cost, isn’t tax-deductible, and is taken to buy an asset that will most likely depreciate. Credit card debt, personal loan debt, and car loans fall into the bad debt category.
9. Be prepared for any health costs
Even for those on Medicare, NHS, or other forms of government care, health care costs can quickly erode spending power and economic security. Out-of-pocket expenses for people in retirement have jumped more than 50% since 2002 – and that doesn’t include the possibility of needing private medical care, or long-term care insurance. Health care costs pose one of the most serious risks to retirement security, and it’s important to understand how to plan for this major expense, navigate the system, and manage your spending.
There are many public and private resources available to help you plan ahead, and private insurance for health and long-term care is much easier to purchase while you are still young and healthy. Do not wait until retirement to seek advice on how to manage medical costs. It is equally important to ensure you are having conversations with your family about your care wishes and ensuring that you have appointed people to act on your behalf if you ever become seriously ill or incapacitated.
10. Avoid outdated assumptions
By the time most investors get to retirement, they have a plan with significantly outdated assumptions. While most people who are near their retirement age may have a sense of the amount of assets they have accumulated, how much they will need to spend in retirement, and how long their money might last, many fail to have these numbers checked against different market conditions.
If the world economy continues to struggle, you’ll need to challenge the conventional wisdom regarding the expected annual rate of return, inflation rate, GDP growth, etc., because any one of these macroeconomic factors can easily derail a carefully crafted retirement plan. Therefore, as a potential retiree, you should consider updating your plan by using a variety of market returns assumptions and other macro factors, assumptions should be used to stress test the plan and updated regularly.
If you retire at the age of 60, the world will almost certainly be a very different place by the time you reach 80 or 90. By retiring with a clear plan that is critically examined and re-evaluated regularly, you’ll have the best chance of having long-term success.