Building for the Future, Enjoying the Present
Most of us work on the unstated assumption that we will spend more years gainfully employed than in retirement. As medical science continues to extend our actuarial lifetime, this may no longer be the case if one retires (or hopes to retire) somewhere between ages 55 and 65.
Imagine this scenario. John and Mary get through school, get their first jobs, get married and “live a little,” start a family and at age 30 decide it is time to save and plan for the future. They are successful and are able to retire at age 60. At age 60 their chances of living until 90 are very high. It is not science fiction that they could spend as many - or more - years in retirement as they did in their productive working years.
Armed with this thought, then, how do they invest during their 30-year work-life to hopefully enjoy financial stability throughout their retirement years?
The reality is that there is no one strategy which can guarantee success. Someone who never risks principal may find their purchasing power in retirement is minimal because their program did not keep pace with inflation. An aggressive investor might find a sharp market downturn seriously eroded their principal so that they are unable to support their desired lifestyle.
The most important thing a family or individual can do to prepare for retirement is to save. Investment returns are unpredictable. There are times when stocks do well, such as from 1982 to 1999, and times when bonds do well, such as from 1982 to 2003. There are times when stocks move sideways, such as from 1966 to 1982, and times when they are negative, such as 1929 to 1941. There are times when bonds deliver only their yield (interest rate), such as the 1930's through the 1950's, and times when they are negative, such as 1975 to 1982. You cannot count upon investment returns to make you financially stable.
What you can count on is the money you save on a monthly and annual basis. It is simple. The more you save, the more you have to invest in whatever style best suits you. The more you have to invest, and the more you diversify, the healthier you will be in retirement.
2. Control taxes.
There is a difference between paying the optimum amount of taxes, and paying the minimum amount of taxes. Paying the minimum can result in foolish investment or spending decisions, just to reduce the amount of tax you owe. Paying the optimum amount means that you have taken advantage of the various tax-reduction techniques available, without taking too much risk or sacrificing your ability to achieve life's many objectives.
3. Invest wisely.
There is an expression we admire: “Success is a journey, not a destination.” An intelligent investment plan increases the likelihood that you will be financially stable as you buy the home your family needs, educate your children and see them marry, and retire on schedule. A sound investment program does not guarantee this, but it does dramatically increase the likelihood you will be a successful investor.
What does such an intelligent investment plan look like? It depends. It depends upon how much time you have until retirement, how much you can be investing on an annual basis, and most of all it depends upon how important “safety” of principal is compared to the opportunity for gain. There is no formula into which you can fit. Your mix of fluctuation risk versus potential reward must be developed by and for you only.*
(*Risk of loss of principal is the most serious kind of risk, and risk of loss of purchasing power is the next most serious kind of risk. However, most people's definition of risk is based almost exclusively on risk of fluctuation of value on a month-to-month, year-to-year basis, when in reality this is not the most pressing risk faced by individual investors.)
Obtaining this balance between freedom from fluctuation versus opportunity for growth is more important than getting the “right” investments. In other words, investing in the stock market is more important than picking the best mutual fund or stock. Knowing what percentage of your total should be in bonds or cash is more important than picking the “best” bond fund or money market account. The same is true for all other kinds of alternative investments, such as real estate, oil and gas, futures, commodities, etc. Investment professionals call this “asset allocation.”
Even the most “intelligent” investment program can fail without two final traits - discipline and patience. A strategy or portfolio may not look good for a year or two, or more, but that does not make it a bad strategy. We admire the investment gurus, such as Peter Lynch or Warren Buffett, yet there were many years and cycles when they did not do well. The reason they now appear successful is that they remained true to their discipline, and they exercised the patience necessary to let their plan work.
4. Balancing retirement plan accounts and “taxable” accounts.
There is a temptation to save for retirement only in formal retirement plans. However, it is very important to build up assets, meant only for retirement, in non-retirement plan accounts, which we call “ordinary” or “taxable” accounts (because you pay taxes now on any income earned). This may seem counter-intuitive. Why would anyone pay taxes now when it can be deferred until later?
Money that is withdrawn from retirement plan accounts, such as IRA's and 401k's, is fully taxable at your maximum tax bracket for the year of withdrawal. For example, if in retirement your only income will be Social Security and $3000 a month you plan to withdraw from your rollover IRA, then your taxable income ($36,000 a year) will be high enough so that a portion of your Social Security will be taxed. This may mean you are in a higher marginal tax bracket than you were expecting.
Imagine you need $36,000 to remodel your home, take a dream vacation or loan money to your children, If your only source for this money is your IRA, you may need to withdraw $50,000 or so to have $36,000 after taxes.
If instead you had a non-IRA account from which you could withdraw the $36,000, the tax hit could be dramatically different. Whatever came from tax-free bond interest would be free of all income taxes. If it came from “qualified” dividends, then the maximum federal tax rate would be 15%. If it came from the sale of appreciated property, such as stocks or real estate, again its maximum federal tax rate would be 15%. And if it came from the sale of investment assets that had no gain, or where there were capital losses available to offset the gain, then none of the withdrawal would be taxable.
Thus it is best if you enter retirement with a healthy balance of retirement plan money and ordinary or “taxable” accounts. Retirement plans arre helpful because you do not pay tax on the money goes in or on its growth, but you will be fully taxed on everything that comes out. The “ordinary” or “taxable” accounts grow with after-tax dollars, but will be available to you in a more tax-advantaged manner in retirement.
One type of account is not better than the other. They both are important. Families that enter retirement with a healthy balance between them will enjoy much greater financial flexibility than those whose must depend upon formal retirement plans for their income.