Question: In a recent column you repeat advice I have often read that withdrawing about 3% of my investment capital will reduce the chances of my running out of money in retirement. But that doesn’t make sense to me. I have been retired for over 19 years and I have sufficient data now to extrapolate that I could live for 100 more years with so meager a drawdown because, through good and bad times, my earnings after inflation and taxes always exceed 3%. If I am missing something, I must be extraordinarily lucky because it hasn’t hurt me yet, and at age 77 I think it unlikely to do so in my remaining years. Can you explain this discrepancy between my experience and the consequences of your advice?
Answer: Sure. You got extraordinarily lucky.
You retired during a massive bull market, which is the best possible scenario for someone who hopes to live off investments. You were drawing from an expanding pool of money. Your stocks probably were growing at an astonishing clip of 20% or more a year for several years. Although later market downturns probably affected your portfolio, those initial years of good returns kept you comfortably ahead of the game.
Contrast that with someone who retires into a bear market. She’s drawing from a shrinking pool of money as her investments swoon. The money she takes out can’t participate in the inevitable rebound, so she loses out on those gains as well. All that dramatically increases the risks that she’ll run out of money before she runs out of breath.
It’s the first five years of retirement that are crucial, according to analyses by mutual fund company T. Rowe Price, which has done extensive research on sustainable withdrawal rates. Bad markets and losses in the first five years after withdrawals begin significantly increase the chances that a person will run out of money during a 30-year retirement.
Some advisors contend that a 3% initial withdrawal rate, adjusted each subsequent year for inflation, is too conservative. If you retire into a long-lasting bull market, it may well be. But none of us knows what the future holds, which is why so many advisors stick with the 3%-to-4% rule.
Dear Liz: I am 56 and will be receiving $175,000 from the sale of a home I inherited. I do not know what to do with this money. I have been underemployed or unemployed for six years, have no retirement savings and am terrified this money will get chipped away for day-to-day expenses so that I’ll have nothing to show for it. Should I invest? If so, what is relatively safe? Should I try to buy another house as an investment?
Answer: You’re right to worry about wasting this windfall, because that’s what often happens. A few thousand dollars here, a few thousand dollars there, and suddenly what once seemed like a vast amount of money is gone.
First, you need to talk to a tax pro to make sure there won’t be a tax bill from your home sale. Then you need to use a small portion of your inheritance to hire a fee-only financial planner who can review your situation and suggest some options. You can get referrals for fee-only planners who charge by the hour from the Garrett Planning Network at http://www.garrettplanningnetwork.com.
You’re closing in quickly on retirement age, and you should know that typically Social Security doesn’t pay much. The average check is around $1,000 a month. This windfall can’t make up for all the years you didn’t save, but it could help you live a little better in retirement if properly invested.
You should read a good book on investing, such as Kathy Kristof’s “Investing 101,” so you can better understand the relationship between risk and reward. It’s understandable that you want to keep your money safe, but investments that promise no loss of principal don’t yield very much. In other words, keeping your money safe means it won’t be able to grow, which in turn means your buying power will be eroded over time.
Dear Liz: We are getting coaching from a finance advisor. He suggests using a home equity line of credit as investment capital. Your opinion on this?
Answer: You’re not dealing with a financial advisor who has your best interests at heart. You’re dealing with a salesman who is mostly, if not solely, concerned about the commission he’s going to earn from selling you an insurance or investment product should you take his unsound advice.
Borrowing to invest is a risky strategy. Putting your home on the line to do so is particularly unwise. The interest rates on your home equity loan may be low now, but the rate is variable and can rise substantially. If you can’t make the payments, you could lose your home.
If he were honest, this is the pitch he would have made to you: “You don’t make enough money to afford the product I want to sell to you. Therefore, I want you to put your home at risk so I can make this commission. Your borrowing costs and the costs of this investment will likely eat up most of your returns, but at least I’ll have my money.”
If he’s selling insurance, you should report him to your state’s insurance commissioner. If he’s selling stocks or other investments, report him to the Securities and Exchange Commission.
If he has any professional investment credentials — which isn’t likely, but anything is possible — you should report him to the organizations that granted those.
Remember that anyone can call himself or herself a financial advisor. There are no education, experience or ethics requirements. If you want someone who meets higher standards, look for a certified financial planner or a personal financial specialist (a designation given to certified public accountants with financial planning training).
And pay attention to how the planner is paid. A fee-only planner accepts only the fees you pay, while a “fee-based” planner may accept commissions from the products he or she sells. If you don’t want commissions to affect the advice you get, consider a fee-only planner.
Dear Liz: Why do you keep saying retirement accounts will earn an average annual return of 8%? We haven’t seen returns like that in years, and there’s no chance we will in the future.
Answer: No one knows what the future will bring. But we’ve been through tumultuous times in the stock market many times in the past. Between the mid-1960s and early 1980s, for example, the Dow Jones industrial average benchmark of stock prices pretty much went nowhere, pinging back and forth between about 600 and 1,000. (Just do a Web search for “Dow Jones history” and you’ll turn up charts that show this.) People were pretty disgusted with stock market returns, and many were pessimistic about the future of our economy. Through the rest of the 1980s and ’90s, though, stock market returns exploded.
In every 30-year period since 1928, stocks have had an average annual return of at least 8%. Those who hung on through bad times were eventually rewarded for ignoring the doom-and-gloomers.
Dear Liz: I just started saving for retirement through my job’s 401(k) plan. I’ve been putting aside $400 a month. I just checked my account to see how it was doing. It has lost over $600! I am trying to save for my retirement — not lose. Where should I invest? I’m considering getting a financial planner to help me.
Answer: The most important thing you need to know about investing is that there is no such thing as a truly risk-free investment.
You won’t lose your principal if you invest in “safe” investments, such as Treasuries and FDIC-insured bank accounts. But you won’t earn enough to keep ahead of inflation. Basically, you’ll never be able to save enough to retire, since the purchasing power of your funds will erode over time rather than grow.
To stay ahead of inflation, you need to take more risk. Stocks over time have consistently offered returns that beat inflation. In every 30-year period starting in 1928, stocks have returned average annual returns of at least 8%. But they certainly don’t gain that much every year, and some years you’ll face steep losses. When you invest in stocks, you have to be prepared for volatility. In other words, sometimes your investments will lose money.
You can reduce that volatility somewhat by diversifying your stock investments (some small companies, some large; some U.S. companies, some foreign) and by including a diversified mix of bonds in your portfolio, along with cash.
A fee-only financial planner can help you design an investment plan that makes sense for your situation. Or you can consider opting for the “lifestyle” or “target date retirement” funds offered by your plan, since they do the diversification and rebalancing for you.
Dear Liz: Is there a reason not to panic? I see my investments tumbling and I am already very conservative. I don’t want to put it all under the mattress, but what else can a person do to hang on to what I have saved? I am fast approaching retirement age.
Answer: If you’re prone to panic, you should turn off the television pundits who like to scare people, which seems to be most of them.
What you need are perspective and balance. If you’re within 10 years of retirement, you should invest in a session with a fee-only financial planner to make sure your portfolio is appropriately diversified. Taking too little risk can be as dangerous as taking too much when you have a 20-year (or longer) retirement horizon.
Over time, the stock market does march upward, although it’s never a smooth path.
Dear Liz: I am 22, single, work full time and have no outstanding debts. I have $18,000 in a savings account and am contributing 15% of my paycheck to a 401(k). How do I invest my savings to get a better return? I’ve been looking into certificates of deposit, money market accounts, IRAs and Roth IRAs, but don’t know enough to start.
Answer: Let’s first get clear on some terminology. CDs and money markets are types of investments, while IRAs and Roth IRAs are types of accounts — specifically, they’re retirement accounts. Think of IRAs and Roth IRAs as buckets into which you put investments, such as CDs, money markets, stocks, bonds or mutual funds.
The next thing you need to get clear about is your plan for your savings. If the money is meant to be an emergency fund, to tide you over in case of job loss or a large expense, then you probably shouldn’t put it in a retirement account, which could have penalties or restrictions on withdrawals.
You also shouldn’t put your emergency fund into investments that could lose value in the short term, such as stocks, bonds or most mutual funds. The best place for emergency money is usually a federally insured bank account. If your bank isn’t paying much interest, you can check with others, including online banks and credit unions, to see if you can get a slightly better return.
If you don’t need the whole sum as an emergency stash, however, then you might want to think about taking more risk to get more return, and perhaps using an IRA or Roth IRA as your savings vehicle. To learn more, check out Kathy Kristof’s “Investing 101″ or Eric Tyson’s “Investing for Dummies.”
Dear Liz: I’ve asked a fee-only advisor, a fee-based advisor and a full-service broker about investing in stocks, and their response is always the same — that I should diversify across multiple investment types, consider my risk tolerance and invest regularly to take advantage of dips in stock prices. They tell me that because I’m young I can be more aggressive with my retirement funds to make them grow. But no matter what these folks say, I think the emperor has no clothes: The stock market is one big gambling venture and we’ve all been scammed into believing otherwise. Frankly, I feel like I’m risking all of my retirement funds by leaving them in the market. (Remember the Reagan-era bust? The dot-com bust? The housing market bust?) Though the stock market seems to be the only game in town (CD rates are 2% or lower, real estate is still risky, who can afford gold?), and those invested in the game tell me I’d be foolish not to play, I feel like I’m between a rock and a hard place. Is this all in my head or do I have a rational basis for my skepticism?
Answer: Remember the Depression? World Wars I and II? The Cold War? The assassination of President Kennedy? Vietnam? Watergate?
Probably not, because you weren’t around. Regardless of the setbacks we’ve faced, however, our economy — and stocks — continue to grow.
Investing in stocks is essentially investing in the productivity of our companies. If you want a graphic representation of that growth, use a search engine to find a chart showing “Dow Jones historical average.” You’ll see that this market benchmark has had numerous setbacks, many of them serious, but its growth has been exponential. The Dow started 1932 at 100, for example; in the 1970s, it bobbed around 1,000; it started this year well over 11,000.
Yes, there will be scams and scandals and people gaming the system. The fact remains that no other investment has the inflation-beating history or potential that stocks have. If you hope to retire someday, a good portion of your portfolio likely needs to be in stocks.
As for gold, here’s another little bit of history you should know. Although it’s been on a tear lately, the price of gold still hasn’t returned to the peak in value it enjoyed in 1980, once you adjust for inflation.
Dear Liz: You recently wrote that if you need your money in 10 years, you should not be in stocks. My husband and I are both in our early 70s and will need some of our money in 10 years. What do you recommend instead of stocks? Read More→
Dear Liz: My mom has BP stock. Currently she is moving toward applying for Medicaid to pay for nursing home expenses, and I was advised to put the stock in my name. Now I am watching her stock (and savings) plummet. It’s gone from a $100,000 savings to about $40,000 currently. Do I take it out, or do you think it will come back and I should leave it alone?
Answer: You may want to cash out at least some of the stock to hire a good elder law attorney who can advise you about the Medicaid look-back rules.
These rules are designed to prevent what you seem to be doing, which is trying to hide assets from the government by transferring them away from the potential Medicaid recipient. Medicaid is the government-run healthcare program for the poor, and recipients are supposed to have exhausted their assets before they apply. Any transfers made within five years of applying for Medicaid will delay eligibility.
As for your original question, having more than 10% of one’s assets in a single stock is extremely unwise, and you shouldn’t have any money invested in stocks if you’re likely to need it within the next 10 years. After you’ve consulted with an elder law attorney you might also want to make appointments with a tax pro and a financial planner so your mom can better manage what she has left.