You’ve started thinking about it.
Your sunset years, and making them as full of leisure and fun as possible…
You know retirement will be sad if you don’t build a whopping big nest egg. Experts estimate a comfortable retirement requires $1.04 million dollars saved up. Factor in even a few years of high inflation and a couple of decades of average inflation, and that million could easily quadruple!
Accumulating that much is a tall order, but if you’re smart about it and avoid major mistakes, it’s very doable.
In the following we’ll detail the 11 worst mistakes that could derail your retirement dreams.
Too Little Too Late
Compound interest has been called “the 8th wonder of the world,” “mankind’s greatest invention,” and “the strongest force in the universe.”
Possibly the most famous story about compounding is the fable of a grain of rice.
Briefly, a clever young girl outsmarts a miserly raja. When he offers her a reward for a good deed, she asks for just a single grain of rice, and then each day for 29 more days, double the previous day’s rice.
In Day 2, she got 2 grains.
Day 3, 4 grains.
Day 4, 8 grains.
Day 5, 16 grains.
On Day 30…
… the young girl received over 500 million grains, for a total of over a billion.
Adapting the story to more modern times by changing the grain of rice to starting with a single penny, by the end of a month, the total is over $10 million!
Of course, doubling your money every day, or even every year, is pure fantasy. Still, the story demonstrates how compound interest can turn small sums into a major fortune.
The flip side is that if you delay investing for retirement by 10 years, starting at age 32 instead of 22, you need to nearly double your annual investment to reach the same amount. Delay to age 42, and the required annual investment more than doubles again.
That’s why starting “Too Late” is a major mistake. The “Too Little” part is self explanatory.
Playing It Safe
Many people look at the stock market with fear. They hear about (or experience first-hand) losses of 50% or more in a single year.
As a result, they play it “safe” with their retirement savings, keeping them in cash or bonds.
The problem is that over a 45-year investing career, assuming the 3.5% long-term average annual inflation, your investment would lose nearly half its value. Set aside $1000 each year for 45 years for a total of $45,000 saved, and keep it in cash, and you’d end up with less than $23,000.
Bonds are a bit better, with a 1.9% average inflation-adjusted annual return. Here, $45,000 invested over a 45-year period would get you over $70,000.
Not bad, right?
Compare it to stocks though, with a historic average inflation-adjusted return of 6.6%. Here, your $45,000 turns into over a quarter million dollars!
This means that if you don’t want to have to set aside 3.6x more each year (if you even could), keeping your money “safe” in bonds would cut your retirement income by more than 70% compared to stocks!
Ignoring the Nickel-and-Diming of Fees
Erroneously attributed to Mark Twain, an often-repeated quip says the surest way to get rich during a gold rush isn’t to prospect for gold, but to sell overpriced picks and shovels to those pursuing unsure fortunes.
This is what many financial institutions, wealth managers, and investment advisors do. They provide investment advice to people seeking an uncertain fortune through investments, and charge a fee for that service. While there’s absolutely nothing wrong with doing so (in effect, selling shovels at a fair price), some charge unjustifiably high fees that come out of your pocket, whether their advice adds value or not.
For example, many mutual funds charge a sales fee, or “load,” to pay commissions to financial advisors who bring them investors. Say you pay an advisor to choose a fund for you to invest in. Given two similar funds to choose from, one which pays him $5 for every $100 you invest, and another that pays him nothing (a “no-load fund”), the advisor invests your money in the former. As a result, if you invested $10,000, you own $9500 worth of shares, and the advisor pockets $500 of your money.
If load funds tended to outperform no-load funds by a wide enough margin, this would be acceptable. However, as finweb.com says, there is no evidence for such outperformance. Indeed, there’s ample evidence to the contrary.
Letting Emotions Rule You
A humorous, but highly instructive story was reported in 2014 by Business Insider. In a Bloomberg Radio show, a guest related the following:
“Fidelity had done a study as to which accounts had done the best at Fidelity. And what they found was…”
“They were dead,” interjected the interviewer.
“…No, that’s close though!” responds the guest. “They were the accounts of people who forgot they had an account at Fidelity.”
Numerous studies show time and again that mutual fund investors underperform the very funds in which they invest.
How is this possible?
Investors act on fear, panic selling when they should hold on. They then act on greed, buying a “hot fund” after it’s run up a lot and is poised for losses. That’s how emotion-driven trading can hurt your long-term results.
Putting All Your Eggs in the Same Basket
Twenty years ago, energy trader Enron, then the nation’s 7th-largest company, became an object lesson in the folly of putting all your eggs in the same basket.
The company loaded their employee’s pensions with Enron stock.
When the company’s accounting tricks couldn’t hide massive losses anymore, shares dropped from $80 to pennies. As NPR reported, “All told, Enron employees [were] out more than $1 billion in pension holdings.”
On top of that, 14 thousand employees lost their job as the company imploded.
Most money managers will tell you to avoid holding more than 10% of your portfolio in a single company (if it’s your own company, things may be different). How much more so, when your portfolio is invested 20%, 30%, or more in your employer’s stock?
There, if the company goes under, your portfolio suffers a massive “haircut,” your pension, if any, may become worthless, and you lose your job, all at the same time.
Following the Herd
In John Bogle’s Little Book of Common Sense Investing, Warren Buffet is quoted as saying, “A low-cost fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth.”
Indeed, if you have no idea about investing, following the herd by investing in the entire market will have you beat many, if not most, active investors.
However, you’re guaranteed to slightly underperform the market (due to management fees).
If you educate yourself on investing, you can find a system that works for you and lets you outperform the market for a very long time, allowing a richer, more comfortable retirement.
Similarly, conventional wisdom suggests you gradually become more conservative with your investments as you grow older and near retirement. Common options of “glide paths” would have you keep your stock allocation at 100 minus your age (so you’d have only 33% in stocks at age 67), or 110 minus your age, or 120 minus your age.
So-called “target date funds” follow different glide paths, but all reduce your stock allocation as their target date draws near, and some even continue reducing their stock allocation after that, when you’re presumably already retired.
CNBC reports that these funds account for $1.8 trillion invested for retirement!
While these funds give you a simple investing solution, their “one size fit all” approach fits many very poorly indeed. Depending on what else you invested in, and what other mitigations you may have in place for a market crash as you near retirement, a target date fund may be too aggressive for you, or the opportunity cost may be higher than it needs to be.
Leaving Money on the Table
Most American workers have access to an employer 401(k) or 403(b) plan, and most employers offer a match for employee contributions. Some are very generous (when I worked at the University of Maryland, we got 7.25% of our pay added to our 403(b) plans, even if we contributed nothing).
Others offer a $0.50 on the dollar match up to a 6% employee contribution. There, if you earn $50,000 a year, and contribute $3000, your employer throws in an extra $1500. This gives you $1500/year of free money, immediately giving you a 50% return on your investment.
Despite this, studies show that on average, employees leave $1300/year of this free money on the table by not contributing enough to maximize their employer’s match.
Stealing from Yourself
Many 401(k) plans allow you to borrow from yourself at lower interest than you’d pay the bank. Indeed, the interest you pay goes back into your 401(k), since that’s where the money comes from.
However, if the interest is lower than the returns on your 401(k) investments, you just stole money from your future self through opportunity cost.
Worse, if you lose your job before you paid back the loan, or you’re simply unable to pay it back, your retirement funds just took a big hit, and to add insult to injury, the IRS will charge you a 10% penalty and taxes on what has become in effect an early withdrawal.
Similarly, many workers raid their old 401(k) funds when they leave a job, rather than rolling them over. Again, this robs their future selves, and they have to pay penalties and taxes on top of it.
Inflating Your Lifestyle
Most workers’ income grows over their career. This because they become more skilled and experienced and/or because they’re able to move to better-paying jobs.
If you start off making $40,000 a year, and manage to score a $10,000 increase through a promotion or moving to a different employer, you have a choice.
You could use the extra income to increase your standard of living, what’s knows as “lifestyle inflation,” or you could divert part or all of the extra income to increase your savings and investing rate.
For many years now, I’ve tried to divert 2/3 of each income increase to my investments, to great effect. By letting myself spend at least some of the increase, I balance this with enjoying some of the fruits of my labor in the present, making this sustainable.
Grabbing the Money Too Early
As another example of leaving money on the table, many Americans claim Social Security benefits as early as they can, at age 62. According to the Social Security Administration (SSA), this can cost them nearly a third of their monthly benefits for life. On the flip side, says the SSA, delaying benefits to age 70 increases monthly benefits by at least 24% for life.
Many people are forced to claim early due to forced early retirement, and many others benefit from early claiming as their ill health makes it likely they won’t survive long enough to make late claiming viable. However, many others who claim early are simply eager to start getting money earlier, at great eventual cost to their financial health.
Ignoring the Tax Man
While many rail against taxation as an unjust seizure of our money, I firmly hold that taxes (at reasonable levels) are a necessary evil. That’s how we fund things like our national defense, federal and state responses to emergencies, the highway system, etc.
Of course there’s plenty of waste, and many cases where lawmakers stuff unnecessary “earmarks,” also knows as “pork,” into legislation. However, that’s a small part of the federal budget.
Regardless of whether you agree with me or not, you have to pay your taxes if you want to avoid going to jail (e.g., mobster Al Capone famously evaded conviction on countless cases of murder and mayhem, but was ultimately undone on tax evasion charges).
While tax evasion is illegal and will drop you in hot water, tax avoidance is perfectly legal. The International Tax Blog offers two relevant quotes from rulings by Judge Learned Hand.
“Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” Gregory v. Helvering, 69 F.2d 809, 810 (2d Cir. 1934)
“Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.” Commissioner v. Newman, 159 F.2d 848, 851 (2d Cir. 1947) — dissenting opinion
There are multiple tax-advantaged ways of saving and investing for retirement, and if you don’t take advantage, your retirement will be far less comfortable.
These include Roth IRAs and Roth 401(k) plans, where you contribute after-tax money, but both the contributions and every penny they make are all tax free. They also include traditional IRAs, SEP IRAs, SIMPLE plans, and 401(k) plans, where you contribute pre-tax dollars, and don’t have to pay any taxes until you withdraw money, and even then, only on those withdrawals.
Best of the lot are Health Savings Accounts (HSAs), where you contribute pre-tax dollars, they grow tax-free, and withdrawals are tax-free as well, so long as they’re used to pay for medical expenses. Given how the average retired couple can expect to pay over $300,000 in medical expenses, it’s a good bet that HSA money can all be spent tax-free.
The Bottom Line
Personal finance, as I often point out, is exactly that — personal. What’s right for me could be completely wrong for you.
However, as the well-known quip goes, “The race isn’t always to the swift, nor the battle to the bold. But that’s the way to bet.”
You may choose to ignore any or all of the above 11 pitfalls, and it may even work out for you. However, in my experience, odds are it won’t.
I’m well aware that this article is unlikely help people in poverty.
For them, making it through to the end of the month is already a major accomplishment. Setting aside anything for the future is likely sheer fantasy.
The above is intended primarily for middle- and upper-middle-class Americans (or those aspiring to get there), and those living elsewhere in comparable privilege.
This article is intended for informational purposes only, and should not be considered financial, investment, business, or legal advice. You should consult a relevant professional before making any major decisions.