For so many people, retirement is a scary word. They hear so many horror stories about people who were all set up to retire, and then the market crashed and they lost half of their retirement or, they didn’t have a plan, and ran out of money. So many stories can make retirement a scary thing to tackle.
Did you know the average retiree only has money planned for eight years of retirement, when in reality they need to plan for closer to 20-25 years?
Nearly all experts today attribute this failure to one major problem: the lack of a clearly written financial plan. When you plan for your retirement, with all the facts in front of you, it is easier to foresee some of the problems that will come up. That isn’t to say that you’ll eliminate all financial problems and never have a hiccup; it does mean, however, that with planning, statistically you have a much better chance to live comfortably during retirement.
To make a plan that works, you must understand the 5 major risks to your retirement:
- The risk of LOSS; also called market risk.
- The risk of losing CONTROL and liquidity of your money.
- The risk of running out of money (INCOME).
- The risk of INFLATiON.
- The risk of TAXES.
I am going to tackle each of these risks one post at a time. First, let’s discuss the risk of loss.
The Risk of Loss (Also Called Market Risk):
Americans have been put in a corner with market risk. Since 1974, when retirement-fund-paying went from the employer to the employee with ERISA legislation, and in 1978 with the birth of the 401(k) section of the IRS tax code, Americans’ retirement money has been put at risk. There are many details with this, but the long and short of it is that Wall Street was able to get pension money away from employers, who typically had invested it in insurance companies, long-term real estate bonds, and other various conservative investments, and instead started having employees invest their own contributions (with a match sometimes from their employer) in the market. This happened when pensions started going away and employees had to get involved with the investment world through 401(k)s and IRAs and become directly responsible for building their own retirement instead of expecting it from their employer. This was a huge windfall for Wall Street investment firms as they now had control over trillions of dollars of retirement money. But, it left the employee at HUGE risk.
Before that, your parents, or maybe your grandparents, went to work for 40 years, were given a gold watch, and then retired on a company pension that their employers were contractually obligated to pay for the rest of their lives. Due to these pensions, the employers were very careful with how the money was invested, and they only put it in conservative, time-tested investments that would not risk the income of their employees. This is called a defined benefit retirement plan, because the benefit (the amount you receive each month) is defined and laid out in your employment contract.
Now, we have a different system. Typically, employers have turned over retirement accounts to a financial firm to make investing choices for you (this is called a 401(k) or IRA). You can contribute specified amounts to these plans, changed every so often by Congress, and your employer can choose to match certain percentages; because of this these plans are called qualified plans, or defined contribution retirement plans.
Since the switch was made to the 401(k) and other retirement accounts (traditional IRA, 403b, TSP, etc.), the risk of making sure your retirement was safe was transferred from your employer over to you. And since you are not likely to be a savvy Wall Street investor with tons of time on your hands to ensure the safety of your investments, YOU take all the market risks and all the losses.
Because you now have the risk of the market, this means you should understand everything your retirement account is invested in. But that rarely, if ever, happens. Typically, once a year, your employer will have the company who manages the funds in their 401(k) plan come to your place of employment and do a presentation about the retirement plan. With little turnout, they typically explain a few ideas to a few people, and leave it at that. Here are some of the problems with this ridiculous process:
- Fuzzy Math. As I have explained in previous posts, everyone has heard that if you leave your money in the market, you’ll get a 10-12 percent return, right? You hear it on talk radio, the financial squawkers on TV, and all over the place. The problem is, that isn’t the full story. That is an AVERAGE rate of return, but what you need to look for is what I call the “cash on cash rate of return,” or what’s actually in YOUR pocket at the end of the day.
Take a look at this fuzzy math:
Even though on it’s face, it looks like the person in the graph will get an average return of 14 percent over four years, they really won’t. With all the ups and downs, that percentage rate is affected by the balance during the ups and the downs. The 14 percent return is not figured on a static $1,000 balance — if it were, by the end of the four years based on this fuzzy math and the 14 percent return on investment, you would have $1,140 in the bank. But you can see from the graph that the person has even a little less than $1,000 in the account at the end of year-four, so that 14 percent return is a bogus number.
Because you take all the risk of loss and Wall Street doesn’t want to lose your business when you feel that risk, they inflate the rates of return in complicated graphs and percentages. The cash on cash rate of return is rarely explained or shown to you. This is why so many Americans feel like they can’t get ahead on retirement!
- Fees. Up until very recently, the fees charged to your accounts were almost completely hidden from you. Legislation has changed that in a way, but all it did was make the financial firms have to disclose to your employer a little more explicitly their fees, but this didn’t have the desired effect of helping employees understand the fees. Fees on 401(k) accounts are still very high, and this takes a huge bite out of your retirement. The problem with this isn’t necessarily the fees, since if the fees are justifiable and the rate of return is acceptable and you agree with it, then you are getting what you paid for and that is fine. But, the fees that are hidden that you are paying and don’t know about, those fees are the problem. You don’t agree to them and they are passed along to you, sometimes for the benefit of the financial management firm, sometimes for the benefit of your employer, and sometimes for the benefit of them both. But, you are left out of the benefit altogether, and it is not disclosed to you.
- Timing of Returns. In a study completed in 2015 by WealthVest, it was shown how significantly the timing of your investment returns can affect your overall net gain. The timing of returns says that if you suffer early losses in your retirement years, it can greatly impact your retirement as you will be drawing on those funds to live, and it can leave your retirement fund decimated. So, according to the mainstream logic, all you need to do is guess correctly when to retire by not having a loss in the first five years of retirement! Good luck with that.
As part of this timing of returns, it is extremely important to understand the Fuzzy Math many financial firms use after a period of losses. For example, in 2008 many people lost a lot of money due to the economic downturn we experienced. Many people lost up to 40 percent of their money, and it was devastating. This is a real risk posed to you if you have all your money in the market. Now, let’s use some round numbers to illustrate the point of timing. Let’s suppose you have $1,000,000 in a 401(k), and it’s 2008. You lose 40 percent just like that and the balance is now $600,000.
This was painful! Remember, this ACTUALLY happened to people. So, how did the media and the financial firms spin it? They said to expect these ups and downs, and to look at the long-term, and to be patient and to keep investing and it would all come back. And, boy did it ever! The year 2009 ended up being a banner year. They showed that even though 2008 was a huge loss, they were excited that 2009 had a 25 percent average return! Most Americans thought since they lost 40 percent one year, and gained 25 percent back the next that they only had 15 percent to go to get back to their original balance, right? Wrong. The problem was the the timing of returns. They lost 40 percent, and the 25 percent gain was based on the balance after losing 40 percent, not the original value of the investment account. In order to come out on top and regain the original amount before the 40 percent loss, gains in 2009 would have had to be higher than the losses in 2008 to recapture what was lost.
Here’s what it looks like:
Original balance: $1,000,000
Profit/Loss in first year: -40%
New balance after first year: $600,000
Profit/Loss in second year: +25%
New balance after second year: $750,000
That means the profit in the second year was $150,000. Fine. But if you still had the original $1,000,000 in 2009 and enjoyed that banner year with its 25 percent return, you would have earned an additional $250,000. So this means that you are behind in terms of time by $100,000.
You just gained 25 percent in a year, a great return, so it seem that you only need to have a few more good years to get the additional $250,000 back. But, in fact, in this scenario if you lost 40 percent you would need a 67 percent return in order to get back to where you were before the market dropped. If you earned 25 percent of it back in 2009 (which was not a typical year by the way) you would still need another 42 percent to regain it all. When people made 25 percent back in 2009 and got all excited about the fact that they made so much of it back in one year, they started believing that they probably had enough time before retiring (if, fingers crossed, nothing crazy happened again in the market) to get it all back. But what they didn’t realize is they actually needed another 42 percent and that there would be no way most of them would have the time to make up this kind of loss. This kind of fuzzy math without a real, honest explanation of how rate of timing works in the market is what has kept the financial firms in business. They make you feel like you’re doing the right thing by investing with them, but you still feel like you are not getting ahead. The general public feels it, but doesn’t know how to put their finger on it, or know what to do about it. “Hmmm, how can that be?” you scratch your head and wonder. Now you know why.
I recently asked a new client about her interaction with her 401(k) planning company at work, and she said they lectured everyone the same way: If you are young, they said, you need to “be aggressive,” and buy riskier assets in the plan to get a higher return. If you are middle aged and getting closer to retirement, (which is where my client is at about 45 years of age), they said you need to “be aggressive” to make sure you make it to retirement. If you are older and getting close to retirement and perhaps a little short on retirement funds, they said you need to “be aggressive” to make up for lost time.
Really? All they are doing is passing the risk on to the clients, probably for some “aggressive” funds that pay them more commission, which can be a breach of fiduciary responsibility. This is all too common, and it can lead someone to lose their hard-earned retirement money, and in many cases I have seen, it delays retirement and causes way too much stress and problems trying to work when people are too old to work.
Market loss is a MAJOR risk to your retirement. If you have most of your money in these risky 401(k) or IRA accounts, I recommend getting solid investment advice from firstname.lastname@example.org. You can get help playing the market, which is what you have to do if you are trying to build retirement using a 401(k). He can help you in this effort. But if you’re thinking it’s time to get into retirement funding that does not require you to absorb so much risk on your own, contact me and I will be happy to discuss at no obligation, the myriad options available to you that will help you build a predictable retirement on ANY income that you cannot outlive: email@example.com.
In my next post, I will deal with the second major risk to your retirement funds: CONTROL.