Three Big Retirement Myths

Here are three big retirement myths from MSN Money:

Myth No. 1: You should replace a certain percentage of your income in retirement.

"This replacement rate was developed by the industry in order to promote sales of their mutual fund products and is inappropriate for most households," Kotlikoff says.

Kotlikoff advocates what he calls "consumption smoothing." That means spending more in your working years, when there are more mouths to feed, and less in retirement, when it's just you and your spouse or perhaps just you alone.

To me, the "plan on spending 80% of your current income (or whatever percent) during retirement" is simply a very rough guide, call it a rule-of-thumb. It's an estimate for those people who don't want to (or can't) calculate what they will actually spend then.

Instead, I recommend that people estimate their actual retirement expenses by making up a mock budget. Of course there will be several things you'll have to estimate and you'll need to update it every few years, but still, it will give you a better picture of what you'll actually spend then the "80% rule."

One other tip I follow is to assume I'll get nothing from Social Security and I save accordingly. This way, I'll have plenty of cushion in case I estimate too low on my expenses (because, in actuality, I'll probably get something from SS.)

So, I guess I agree with them on myth #1.

Myth No. 2: You should hold a combination of stocks and bonds in your 401(k).

If you have both tax-deferred retirement accounts and regular investment accounts, you should hold stocks in the regular accounts and bonds in retirement accounts to reap the best tax rewards, Kotlikoff and Burns argue. Equities pay their returns as capital gains and dividends, which are taxed at a 15% rate or lower, depending on income. Bonds pay out interest that is taxed at the income tax rate, as high as 35%. But everything you accrue in a tax-deferred retirement account -- be it capital gains, dividends or interest -- is taxed as income at the higher rate when you take the money out.

I have a small percentage of my asset allocation in bonds and all of them are in tax-deferred accounts. This isn't to say that my only investments in tax-deferred accounts are bonds (I have stocks in them as well), just that all my bonds are in tax-deferred accounts (none in taxable/regular accounts).

Now I'm with them two for two. Here's the last myth:

Myth No. 3: A broker can help you get higher returns.

Although many money managers vow to beat the market, the odds are against it.

"About 80% of mutual fund managers underperform the market," Kotlikoff says. "In addition to buying securities that are risky, you are buying a money manager who is risky, and you are also paying a high price."

"You can do all this stuff on your own without paying high fees," Kotlikoff says. "Just invest in index funds for stocks and TIPS for bonds."

Oh yeah, they're singing my song now. ;-)

Comments

[rwh]

If I have a balanced portfolio in my retirement account and also have stocks and cash outside of my retirement account, should I rebalance the retirement portfolio to all bonds just before I retire (particularly in my Roth IRA), while continuing to hold stocks and cash outside the retirement account?

[RDS @ Smart Financial Values]

Thanks for highlighting these myths. They are all great points. Back when I was a financial advisor I was shocked at how many people used the 80% or 70% rule of thumb to estimate their retirement needs without thinking at all about how or why their income needs would change. While it is accurate for some people, for others it can be much too high or too low. In order to estimate retirement needs I recommend that one starts with their current income (if within a few years of retirement) and move it up or down based on what would change after retirement.

[Sarah]

I don't think you do agree with them re: no. 2, since their main point there is not to put stocks in tax-deferred accounts and you are saying that you do. No?

[poor boomer]

One advantage of being chronically poor is that your financial constraints smooth your consumption for you - little or no effort is required.

[kitty]

They may have a point in 2. One thing to keep in mind though is that 401K holdings aren't in individual stocks but in mutual funds. Mutual funds pay capital gain distributions whether or not you yourself get profits. For example, this year in spite of all the losses, many funds had distributions because they were forced to sell many "winners" because of withdrawals. Keeping equity funds in tax deferred accounts avoids taxes on capital gain distributions. You pay taxes when you withdraw the funds, but you don't pay taxes on money you don't actually see.

Similarly with bonds, in 401K you cannot buy individual bonds, only bond funds. Bond funds are different investments from individual bonds since while individual bonds come with a guarantee to return you your principal at maturity (unless the issuer goes belly up) and a fixed interest, with bond funds there is no such guarantee. Bond funds go up and down with bond market and hence carry an element of risk that individual bonds don't. So if you want bond funds, it makes sense to keep them in 401K. If you want individual bonds, you can buy them inside an IRA, but not in 401K.

Also, the interest on municipal bonds is tax free from federal tax and in case of bonds from your state - state tax as well. So, it makes sense to keep municipal bonds in a taxable account.

My 401K is about 50% equity funds. The rest is 2/3 stable value, and 1/3 in investment grade bond funds and a little in treasury inflation-protected funds. I actually moved some money into investment grade corporate bond funds from stable value a couple of months ago as I felt the credit crisis made the corporate bond market attractive. I don't plan to hold it there for long, probably only until the credit situation improves. Then it'll be either stable value or equities or both -- I don't personally like bond funds.

My taxable acccounts are divided between individual stocks, individual bonds (treasury I bonds, municipal and corporate), cash and CDs. I started to buy municipal and corporate bonds only last month, so for the moment I only have a small percentage. I did, however, managed to get attractive yields taking advantage of the credit crisis. The yields came down a bit, but they are still attractive. I'd like to increase my individual bond holding, hopefully I'll find some money to buy a couple more issues while the yields are still above normal.

[Mr. GoTo]

I understand the basis for saving as if Social Security will not be there for you. On the other hand, this assumption is false and will sometimes lead to excessive risk taking on the investment side. Assuming that SS will not be there is something that companies selling stocks and annuities want you to believe.

[FMF]

Sarah --

I agree with their philosophy of bonds in tax-deferred accounts and stocks outside of them. That said, my asset allocation calls for way more stocks than bonds. The bonds I do have are in tax-deferred accounts, but I have more tax-deferred funds than I want to allocate to bonds. So I keep the "extra" portion in stocks. Make sense?

Mr. Go To --

You can't say that the assumption that SS will not be there for me is false. Can you read the future? Neither can I. That's why I'm preparing for the worst. I'm not taking excessive risk -- just saving more in my regular choice of investments.

[Rod Ferguson]

Mr. GoTo:

There is also the matter of what sort of payout you will have and the value of those dollars when you retire. Use http://www.ssa.gov/OACT/quickcalc/index.html to get a rough idea of what you'll be getting in today and future dollars. Bear in mind that "future dollars" are calculated with CPI increases - not the purchasing power of those dollars. To get a rough idea of purchasign power, take "todays dollars", figure out what they can buy, figure out how much those things cost 20 years ago and apply the percentage difference to 20 years hence. You should discover that the extra 50% or so COLA increase will not keep up with the 100% or so increase in goods and services (over 20 years).

And, before you dismiss the thought of SS not existing (or changing radically between now and when you retire), you should go read the definition of "counterparty risk" and apply that definition to government policy over the last 50 years. It's not a crazy idea.

[SC]

I have a question on investing. Let's say I bought a stock, mutual fund or whatever at $5.00 per share and hold for 10years. It goes up 50% one year down 20% the next year and fluctuates up and down for 10 years. After 10 years when I am ready to sell, the share price is back to $5.00. Does that mean I haven't made any money for holding the share for 10 years?

[FMF]

SC --

You may have earned dividends along the way, but in the absence of those, then yes, a $5 price then and $5 price now means you earned nothing.