Don’t Let Fear Paralyze Your Retirement Plan

 
It’s understandable that the prospect of retiring has become increasingly scary for a lot of people.  Emily Brandon’s recent piece at U.S. News explores some of the fears uncovered by a recent Financial Engines survey of 300 retired and soon-to-be retired people.  Unfortunately, this fear is causing some folks to simply throw up their hands in despair:

“Some individuals were paralyzed by the uncertainty and took no action in order to avoid making incorrect decisions. This inertia caused some retirees to choose conservative investments to avoid getting locked into something and not having access to their money.”

Whatever you do, don’t do nothing!

It’s true, there is a lot of advice out there on how much to save, how to invest it, and how to make it last—some of it conflicting and all of it overwhelming.  But that doesn’t mean it’s better to take none of it.  Standard rules of thumb have been getting a bad rap lately.  True they are not precise, but at least they give us a place to start. 

How much to save

Last week I wrote about the 4% rule.  Is it perfect?  Of course not, but it’s a great place to start.  It will give you a target.  All you have to do is adjust for your own circumstances.   

From paralysis to action:  Aim to save 25 times your annual retirement budget needs that will not already be met by Social Security if you are planning to retire near age 65.

How to invest it

Is the age-based rule of thumb for allocating your assets perfect?  You know what I’m going to say:  No, but it’s a good place to start.  Should your allocation between bonds and stocks be 30/70, 60/40 or somewhere in between?  It’s up to you.  There really is no wrong answer here, well, aside from putting 100% of it in stocks or bonds, or your house, or the mattress.  Start with the basics and adjust for your own risk-tolerance as explained in this article:  Should You Invest According to Your Age?

From paralysis to action:  Just pick an allocation, you can always change it.  Invest it in a diversified selection of low-cost index stock and bond funds. 

How to make it last

Rebalance your portfolio periodically.  I don’t even think this rule is controversial.  As the years go by, your target allocation is going to get out of whack.  The market will impact your allocation and so will your own withdrawals.  Rebalancing will force you to sell stocks when they are high and buy them when they are low.  You’ll also want to rebalance simply to shift to a more conservative allocation as you age.

My approach to asset allocation is to always have about 10 years of living expenses in bonds and cash so that I won’t be forced to sell stock mutual funds during market tumbles. 

Putting it all together

Let’s assume you are retiring at 65 and planning on a 4% withdrawal rate.  You will need at least 40% allocated to bonds (40/60 allocation) to have 10 years of living expenses in your bond allocation.   Assuming your portfolio returns about 2.5% over inflation, you will need to migrate toward a 50/50 allocation by your 75^th birthday to maintain a 10 year supply of liquid assets.  If you continue to periodically rebalance to keep that target of 10 years living expenses, your allocation would shift to about 70/30 by the time you are in your mid-80’s.

A recent survey showed that many people’s paralysis is causing them to make a different plan for retirement all together:  never retire at all.   My issues with that action plan are in my post at U.S. News this week, Denial is Not a Retirement Plan.

 

This is a post from Retirement:  A Full-Time Job.

 

Comments

[Satisfyingretirement]

I'm glad you are addressing this issue. The media and researchers seem to have fallen in love with the idea that because some retirees are facing problems, all retirees are in trouble.

While that message draws attention, it creates the sense of panic and paralysis you mention. Doing nothing is the worst possible choice.

[Penta]

Great Post....One thing that has me stuck in the mud is trying to figure out how to invest the bond portion of my portfolio. If you just buy a "bond index fund" when overall rates are this low, your setting yourself up for losses as interest rates inevitably rise from historic lows (e.g. they have nowhere to go but up as can't go lower than zero). And if to combat this you keep your money invested in a money market fund and wait, you'll be waiting at <1%....So any "specific" advice on how to play this would be very welcome...

[Retired Syd]

@Penta: You have a very good point, in this interest rate environment you're better off in funds with shorter maturities. No, the rates won't make you much money but you'll preserve more principal as rates rise.

[Almost there]

How about a laddered bond fund? Short term & do take advantage of interest rate increases. Nice for this sort of environment...

[Penta]

Thanks "Almost There". Have been looking at ladders, but if you really think it through, to implement one today (or buy a bond fund) would just mean your buying a bunch of bonds when rates are at historic lows...Then when they rise, prices will go down and the story ends badly....So the best alternative I've been able to come up with is to park my "bond money" in a money market earning 1.1%, and wait...This feels like a terrible option but at least when interest rates increase, my returns will as well..., and more importantly, this will keep funds liquid to buy bonds later when yields improve...But I'd love to know if there is a smarter answer....

[Sightings]

Saving is a lot like dieting -- you can read all about it, but the only way it works is if you can learn to postpone gratification. But (check me if I'm wrong), you don't have to SAVE 25 times your annual budget (which is a LOT of saving), but you should HAVE 25 times your annual budget when you retire. Presumably, a lot of that money will come from your investments over the years (and maybe even some employer match), so you don't have to save that much.

Which makes it seem more doable.

And bonds ... don't get me started on bonds. At these rates, they're for suckers.

[Jacq]

Syd, here's a book you might like on retirement:
http://www.amazon.com/Experience-Retirement-David-J-Ekerdt/dp/0801472520/ref=sr_1_1?ie=UTF8&qid=1306676228&sr=8-1

Re. the 25 times annual budget to be saved - in Canada, there was a StatsCan study that ~ 50% of household income in retirement comes from government programs. That provides 40-70% of the essentials only for retirees (depends on how spendy you are) - but not enough to cover any of the lifestyle expenses.

So if you're not prepared to reduce spending by quite a lot - people will have to work to make up the shortfall or to have any fun. Reducing spending was probably much easier for the older generation of retirees due to their general tendencies towards thriftiness.

[Retired Syd]

@Sightings--absolutely right, I should say you need to accumulate 25 times your annual budget rather than "save" 25 times--that would indeed be hard.

But I wouldn't give up the bond funds all together. Yeah, the returns have been practically nothing the last couple years, but the stock market has risen 40% in 2 years. So a 50/50 mix would have returned you 20%, which isn't 40%, but think of the alternative--a down market. At least you've preserved the nest egg on half.

Most of the data shows that the mistakes people make by market timing are a lot worse than the mistakes they make from picking the wrong allocation and sticking by it.

[Penta]

Syd - I agree with your logic of having a balanced portfolio 100%....But that doesn't imply that you should consciously put 1/2 of your assets in a losing investment, just because the other half has done well...Bonds will lose money in the next couple years as interest rates rise, (its just math) so don't fall victim to a rule of thumb that makes you feel like you have no choice...I'm not sure what the best alternative is (that's why I'm raising the question), but even a mmf will do better than losing money...

[Retired Syd]

@Penta: This is a perfect example of not letting fear cause you to do nothing. The difference between putting your money in a MMF or a short-term bond fund right now is not worth worrying about, in my opinion. As rates go up, you'll get hit a little harder on the short-term bond fund, but we're not talking big differences here, and I'm not sure it's worth trying to time.

We can worry about these minute differences or just jump in and get started. I'm not sure we should get hung up on this one, it's just not that material to the overall picture.

That was the real point of the post, to get something done, getting hung up on the intricacies is counter-productive. The difference is just noise.

[dgpcolorado]

@Penta, You have the right idea: Bond funds have always been problematic because they don't "mature". Buying individual bonds (munis and some corporate bonds can be had at decent rates these days) doesn't have that problem. Regardless of how interest rates fluctuate, you just hold the bonds to maturity and then invest the proceeds in something else (or use some of it for living expenses, depending on where in retirement you are).

This gets to the idea of a ladder: if you buy bonds (or CDs) with a ladder of maturities, as each one matures you invest the proceeds in the longest maturity bonds of your ladder then available, which usually have the highest interest rates. So, a ladder might have one, two, three, four, and five year bonds. As each one matures you buy new five year bonds to replace it, thus keeping the ladder going.

As you point out, the problem now is that interest rates for shorter maturities are so low it is hard to get started. But if you were to set up a ladder now, each year, as interest rates rise, your total yield will gradually increase as you roll the maturing bonds into new longer ones. Assuming that you buy bonds that have a positive "yield to maturity" (YTM) you can't lose money even if interest rates rise (assuming that you pick bonds that don't have significant default risk). Rather, you just won't make as much as you might have if you had waited a bit. (That kind of second-guessing can drive any investor crazy, so try to ignore it.)

That's the theory anyway, and it WILL NOT work with bond funds. However, with interest rates so low nowadays, it is perfectly reasonable to park the bonds/cash portion of a portfolio in a plain savings account. Discover Bank offers about 1.15% on on-line, FDIC insured, savings accounts at present. It's a low yield but at least you can't lose money on it, unlike what can happen with bond funds as interest rates rise. So, your idea of just waiting out the current very low interest rates is perfectly valid. IMHO, of course!

[dgpcolorado]

One more thing, before Syd corrects me, when I say one "can't lose money" on a savings account, that doesn't take into account the loss of purchasing power due to inflation. Bonds or cash equivalents don't usually do a very good job of keeping up with inflation (TIPS and Series I Savings Bonds excepted). Keeping up with inflation is the job of the stock portion of a portfolio.

[Retired Syd]

@dpgcolorado: No correction coming from me. In today's environment, there's nothing wrong with your bond allocation being heavily weighted in cash. I just use the word "bonds" to distinguish from the stock allocation. Perhaps "equities vs. fixed-income" is a better way to phrase the intent of allocating your assets. Whether you put that part in bonds or in cash isn't really all that important. Just that you have some part of your nest egg allocated to that asset class (of capital preserving assets.)

[Penta]

Certainly not trying to be difficult, but the statement "Whether you put that part in bonds or in cash isn't really that important" is really interesting as there is an enormous Wallstreet industry built on selling the virtues of "bonds" versus cash...Further, research on balanced portfolios typically cites "real" long-term returns on equities at ~6.5% and "real" returns on bonds at ~3%...If bonds and cash are interchangeable, and can both be counted on to return 3% above inflation, then it would certainly makes the management of a portfolio a heck of a lot easier...! I wish this were true, Syd...! We could just get rid of that pesky bond market that dwarfs the size and magnitude of the equity market...

[Retired Syd]

@Penta: You're not being difficult, but you're missing the "in today's environment" part of my statement. In today's environment, there's not much difference.

I'm still keeping some in short term bonds, some in cash. Right now, there's not much difference between the two. And we're definitely not going to achieve 3% over inflation in the near term, but I'm going to be retired for about 40 or 50 more years. At some point we'll return to a higher interest rate environment and sitting on all cash won't be the best decision. But right now, I don't think it matters. Over the 50, it probably will.

The more important issue here (rather than the cash vs. bonds discussion) is the point about allocating and rebalancing. The fact that I've practically earned nothing on the fixed income part over the last couple years doesn't really matter to me since the equities part has returned 40% over that time. That's why we allocate. Some day down the road, when the interest rate environment is better, I'll shift from shorter duration bonds to longer durations and hopefully juice up the returns on that part (and protect against the inevitable ups and downs in the equity portion of the portfolio by keeping that in balance with my target.)

I'm just trying to say that the decision between MMF's and short term bonds right now shouldn't weigh so heavily on you. You really can't go THAT wrong here.

[Penta]

Good discussion...And it teases out that there is a little more to the process than simply saying "Just Invest in a diversified selection of low-cost index stock and bond funds"....Because the reality is that a little "timing" is required..., So it might actually be a little more accurate to say, "Just Invest in a diversified selection of low-cost index stock and bund funds, eh em, but just don't do that part involving the diversified bond fund, until later.
:)>

[Annie]

People are often too conservative in their retirement years and their money doesn't stay relevant (Keep up with inflation) Diversification is key. Many folks out there seem to think bonds are the next bubble and that if interest rates do rise than bond prices will fall. The unfortunate thing is that people consider their bond investments safe. They can rise and fall just like stocks. I know many are looking to use TIPs for their bond portion.

[Wade]

Sydney, You have an interesting blog about retirement!

I wrote the following comment for your US News and World Report blog, but I thought I'd add it to your personal blog in case you don't see the other one. My comments are not about the particular blog post above:

I came across this particular blog post which was written on about the same day I finished writing an article about "safe savings rates" in which I explain why I think the traditional retirement planning advice you are describing is wrong. This article is in the May 2011 Journal of Financial Planning.

http://www.fpanet.org/journal/CurrentIssue/TableofContents/SafeSavingsRates/

Also, I've seen your more recent blogs about using the 4% rule. I've written some papers questioning about this for recent retirees. I summarized the main ideas I have about this in the following short paper:

http://ideas.repec.org/p/pra/mprapa/31122.html

Thank you and best wishes, Wade