Most common retirement planning mistakes
(MoneyWatch) Millions of baby boomers are approaching retirement as unprepared as Aesop's grasshopper. Here are 18 reasons why that's the case.
They take Social Security at too early an age. While there are many factors that go into the decision of when to take Social Security (such as life expectancy, year of birth, level of benefits, whether or not wages will continue to be earned, issues related to a spouse), in many cases the best decision is to defer the benefits as long as possible. The reason is that the implied return on delaying Social Security is about 8 percent a year. That's by far the highest riskless return on investment one can earn. Delaying is one way of purchasing longevity insurance.
They underestimate the value of an immediate fixed annuity. Many retirees fail to consider the "risk" of living longer than expected -- increasing the risk that one's financial assets will be depleted. An immediate fixed annuity hedges that risk. Thus, they should be considered part of the retirement toolkit.
They underestimate the need for long-term health care. It's now estimated that about 60 percent of people will eventually require 24-hour skilled nursing care in a long-term care facility. Yet, it's estimated that perhaps only about 10 percent of the over 70 million baby boomers actually have a policy that will cover the costs of long-term care. Costs are now approximately $70,000 a year, though in some regions, such as New York and California, it's much higher.
They take withdrawals from the wrong location. The most efficient order is to first draw down the taxable accounts, then the tax-deferred accounts (such as IRAs and 401ks) and finally the non-taxable accounts (Roths). The rationale is that by withdrawing from the taxable account first we allow the assets within the IRA to continue to compound tax deferred. The exception might be that if by delaying withdrawing from an IRA the required minimum distribution (RMD) would be increased to the point that the recipient would be pushed into a higher tax bracket. In the case of the Roth, because the assets are never taxed, they should be the last assets to be withdrawn as we want them to continue to grow tax free for as long as possible.
They fail to consider "stretching" an IRA to allow tax-deferred growth for the duration of beneficiaries' lives. The benefits of deferral include easing of the tax burden and continued tax-deferred growth. In addition, beneficiaries can stretch the RMD over their life expectancies (determined by the IRS). And a child with an inherited IRA can stretch distributions longer than spouse. Investors with multiple beneficiaries should split IRA into separate accounts as each beneficiary's life expectancy is used to determine the RMD. If the IRA isn't split, the oldest beneficiary's age determines the distribution period. Once the account is inherited the beneficiary has the option of taking whatever distribution they would like -- providing the most flexibility.
They underestimate the importance and need for diversification. When investors approach or enter retirement they often make the mistake of believing that their horizons are too short to diversify their stock holdings to such asset classes as small-cap stocks, international stocks and emerging market stocks. However, diversification across non-highly correlating asset classes is the winning strategy no matter what the investment horizon. Diversification across equity asset classes is actually more important as the investment horizon shortens. This is because any asset class can underperform by a very large amount over even fairly long horizons, let alone over relatively short ones. Diversification reduces the risk of any single asset dragging down the portfolio.
They underestimate the risks of inflation. The impact of inflation can be devastating. Historically, the rate of increases in wages has exceeded inflation rate. So while employed the risk of rising inflation isn't great. However, once we enter retirement the risks of inflation increase. One reason is that social security benefits are indexed to inflation, not to the cost of living of seniors. Historically, the cost of medical care has risen at a faster than overall inflation. Given the increased risks, those in retirement should give strong consideration to investing in TIPS instead of nominal bonds.
Having covered 18 mistakes individuals make when planning for retirement, it's easy to see that there are many challenges to developing a well thought out retirement plan. Unfortunately, not only can mistakes be very costly, they can also be difficult to recover from. The potential for costly errors highlights the importance of the planning process.
In closing, the following two recommendations are offered:
- Because the cost of being wrong can be great it is important to be conservative in the estimates used. That applies to estimates on life expectancy, rates of return, withdrawal rates, ability to work in retirement, need for long-term care and so on.
- Those who have options can be more aggressive in their assumptions. Options include the ability to work longer than planned, sell a second home, downsize an existing home, move to a lower cost living area, cut non-essential living expenses and taking out a reverse mortgage.
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