The February issue of Consumer Reports has an article entitled “12 Money Mistakes That Can Cost You $1,000,000.” Interesting. Let's take a look...
1. Investing too conservatively during retirementActually, I'm not going to go any further than that. This is just plain dumb. At first I though/hoped the writers were just referring to people in their working years. But it's for retirees! For a "respectable" consumer magazine to say being in bonds in retirement is (basically) a bad idea is scary.
Conventional wisdom has long suggested that as retirees age, they should shift money out of stocks and into more stable investments, such as bonds. But the problem with bonds is that their annual returns may barely keep pace with inflation, while stocks, over time, typically provide returns significantly above inflation. And inflation can be a retiree's worst enemy.
[We] analyzed how well a range of stock-and-bond portfolios would have performed, using data from 1940 through 2006. We assumed that our hypothetical investor retired at 65 with $500,000 in savings to invest. We also assumed withdrawals at 3 percent each year during retirement and adjusted returns for inflation.
On average, over a variety of 20- and 35-year periods from 1940 through 2006, an all-stock portfolio provided our investor with $750,000 more than an all-bond one. If we had started with less money, $250,000, the advantage of all stocks over all bonds was about $360,000.
What you can do. Weight your asset mix as heavily toward stocks as your comfort level allows. If all-stock gives you the willies, consider, for example, an 80/20 or 70/30 stock/bond mix.
Among my problems with this:
- Standard draw down models are based on a 4% withdrawal rate, not 3%. This lower rate amounts to a $5000 difference ($15k to $20k in the first year). Using a smaller number gives a greater advantage to the long term returns of stocks since it depletes them slower, yielding more compounding and less detrimental effects in down markets.
- What is the point of comparing all stocks to all bonds? That is a ridiculous comparison that shows no understanding for the benefits of diversification! How about comparing 70/30 to 30/70? Or providing actual data on which rolling periods had advantages. How did the retirees in 1973 fare for the next 20 years? And don't forget, the 20 or 35 year data for new retirees in 2000 isn't included. And I'd be willing to bet the difference between 100% stocks versus 80/20 or even 60/40 is very minimal, and that's because of diversification, which allows one to buy low and sell high.
- It makes the highest returns the goal, rather than the lowest risk to meet one's goals. Heck, if one was interested in the highest return, find the asset class with the highest returns and put everything in that. No diversification--just ride out the dips!
This is very irresponsible of CR IMO. I originally found out about the piece from a personal finance blog in which somebody commented on the bonds statement. The comment made it sound like the advice centered on not having bonds in tax advantaged accounts (401k's and Roths) because that's where you wanted your growth. What I found is much worse. But I'd still like to address that point--placement of bonds in a portfolio--since it came up at the investing meeting I had last March.
The intuitive thought is that high return investments (stocks) should go in tax advantaged accounts and low return investments (bonds) in taxable accounts, which is largely because of the capital gains bogeyman I think. However, it's probably better to look at investments at how they are taxed and place them that way:
- Bonds: most of the returns are based on dividend income taxed at ordinary income tax rates
- Stocks/stock mutual funds: most of the returns are based on an increase in the price. they are not taxed until sold.
That same investment in a stock fund happens to return 7% and has no dividends. The total after 10 years is $19672. Ah, but capital gains! We're in a good period of capital gains, 15%, so that results in a tax of $1450, leaving a total of $18,222
Flip the investments into a 401k that gets is withdrawals taxed as ordinary income, the 10k in bonds accrues to $16289, which after taxes is $12217. For the stock fund, still $19,762, but taxes reduce it to $14,821.
the 50/50 mix with bonds in taxable totals $29,271. the 50/50 with stocks in taxable is over $30,439. $120/year isn't *that* huge, but then again a $20,000 portfolio is pretty small.
This demonstrates if you have low return, taxable investments, they belong in tax deferred accounts because taxes erode their annual returns. the gains from stocks, however, are tax deferred, so you get a greater benefit from compounding since taxes have been delayed.
In terms of tax planning, this also demonstrates that while it's great to contribute to a 401k, since everything is taxed at ordinary rates on withdrawals and the government requires withdrawals, there are benefits to making it "safer" while the real growth happens in other accounts.
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5 comments:
Ah... Consumer Reports.
I think Consumer Reports is a fantastic resource if they are reviewing a subject you don't know anything about.
Obviously, the problem there is that if you DO know something about it, it does this, which is just irritate you. Then it makes you realize that if EVERY time it's about something you know that they're wrong (or at least misguided) maybe it isn't such a good resource for those things you know nothing about.
Of course, there aren't any good alternatives. Baby/child car seats are a perfect example. You have no independent way to judge their safety other than CR, and that seems to be a crap shoot.
Re-read your previous comments. We're in violent agreement.
Have you done an analysis of the advantages of the new Roth 401k vs the traditional. My cursory investigation seemed to indicate that the Roth was a better way to go in almost all cases. The only ones where it wasn't were when:
1) You invested the delta between the pretax and post tax costs (ie 401k + what the Roth overhead is due to it being post tax)
2) You had a very low income tax bracket now and expected a very high one when you retired.
For #2, if it wasn't at the extremes it didn't seem to matter.
I'm also getting curious about what to do about "bridge" savings. Although I expect to have an adequate amount for retirement, what happens if I want to stop working early? The penalties for withdrawing money before 59.5 mean that I'd need a decent nest egg outside of the "traditional" retirement accounts. Seems like there ought to be a more clever way to handle that than simply investing in standard taxed investments.
Re the Roth 401k, that is not an option for either of us at this time. I have a 403b, and as good as Freescale's benefits package is, no Roth as of yet for Joanne.
For kicks, I checked out a couple of savings calculators. They all said maxing everything out now means we'd have a standard of living at retirement multiple times better than we currently enjoy. Of course, this assumes realistic assumptions of returns are made.
I remember reading some articles last year (maybe even 06 before i really started to focus on it) that the push to save for retirement is a marketing push by fund companies to get more assets under control (more fees, collections of expenses in funds). Based on our budget, I think in retirement we could live on about half our current income (standard percentage in these calculations is 80%), as the mortgage is about 1/3 of our spending, and that ideally isn't around when we hit our 60s.
Re early retirement--basically investing in broad market indexes in taxable accounts is very tax efficient until you go to sell since there is minimal turnover to generate capital gains distributions. There are dividend payouts, but that's not too big of a hit. There are also tax managed accounts that minimize taxes while you hold them. Then, in retirement, you divest count on capital gains being lower than marginal tax rates, which is low, since you don't have a paying job and aren't required to take 401k distributions.
And regarding Roths, either in 2010 or through 2010, it's possible to convert 401k/IRAs into Roth accounts. It can be a big tax hit though.
The perk re early retirement is that roth *contributions* (ie, what you put in) can be withdrawn without penalties. I'm not sure how Roth 401k's or converted accounts are treated though.
>the mortgage is about 1/3 of our >spending, and that ideally isn't >around when we hit our 60s.
So, I hate having a mortgage. It is a big payment just sitting there, BUT is not having it the best bet? If you have a low interest rate that cost of borrowing (lowered even more by the tax effect) is often lower than what I can reasonably expect to earn in investements. If my interest rate is 6%, and tax bracket is 25% then the cost of using other people's money is only 4.5%. I can expect to beat that in the market easily, with long term historical returns being around 7%.
As for the inability to borrow for retirement, if we ignore my little rant above, then a reverse mortage makes great sense.
That being said, I don't want one when I retire and I fully plan to avoid reverse mortgages.
I hit on the mortgage issue in a draft post (that probably won't be posted) in much the same way--my disdain for debt:
[Discussion of where to trim budget to afford LBA]... our mortgage. We paid about $2500 extra in principal, which is good. But in financial terms, it could be considered unnecessary since we have a good interest rate. We benefit from keeping our money, rather than paying off debt, since the investable difference is likely to make more (market willing) than the we pay off (also taking into account the time value of money). This is an area I struggle with, as I don't like debt. We used the Freescale windfall to pay off both cars (along with cash on hand, since we didn't have a real investment plan at the time). But the premise is that keeping more invested to take advantage of compounding is better than being in a rush to pay off the debt. Another point, which applies to us, is that our mortgage interest is fully deductible. This isn't the case for everyone. Often MI is the reason to itemize, but that doesn't make the interest worth $12,000. It's only worth the marginal difference beyond the standard deduction.
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