Wednesday, October 17, 2012

Preparing for Retirement: It’s Not About Financial Returns

Preparing for Retirement: It’s Not About Financial Returns

A friend of mine sent me an academic study that discussed the most important factors in preparing for retirement.  If you ask a money manager or stock broker, he will probably tell you that it is asset allocation: the proportion of your money invested in stocks, bonds, and real estate.  After you’ve got the appropriate allocation, he’ll suggest that manager selection is the next crucial element.  I call this the “easy answer.”  You simply put some money into financial assets and let your money work for you.  After 20 or 30 years your pension will be funded. If your money isn’t growing fast enough in conventional stocks or bonds, there’s always hedge funds or private equity to boost returns.  This is the advice proffered to both individuals and institutions, and it’s not sound advice.  If you follow it, money managers are the only ones who consistently profit.

Pension Matters (2004)

As the academic study demonstrated, your savings rate is the key to preparing for retirement.  Put differently, it’s all about how much income you set aside.  Most investors prefer the “asset allocation comes first” advice because it implies that you can have it all.  You can spend like a drunken sailor, and the magic of the markets will take a small amount of capital and turn it into a retirement nest egg.  Wall Street has been selling this hokum to public pension plans, endowments, and you for years.  In the 1980s and 1990s, the advice seemed to work, as financial returns increased by double digits.  However, the last decade has demonstrated that this is a lousy strategy.

Here’s the deal.  If you are 25 years old, you need to start saving money and investing it for the future.  It is going to take you 40 years to build up enough savings to retire, especially in this era where there are fewer and fewer defined benefit plans.  There are no shortcuts; and don't look at your money manager or broker as a role model.  Just because he drives a fancy car and talks about retiring at age 50 doesn’t mean you can do it.  Remember he’s been earning commissions and fees on your money, which gives him a big head start when it comes to accumulating wealth.

If you are 50 or 55 years old, and didn’t get around to saving money until recently, you aren’t going to retire any time in the next 20 to 25 years.  There isn’t a magic investment solution to your problem.  Financial markets will not bail you out.  If you decide to stick your money in aggressive investments, you’re as likely as not to discover that your losses exceed your gains.  This probably is not what you want to hear, but it is the reality of your retirement prospects.

As you contemplate your retirement resources, do not forget about your house.  While the housing market took a big swoon about five years ago, a primary residence is still a good source of retirement value.  However, if you’ve used your house as a piggy bank, continually refinancing to extract equity in order to take vacations, purchase second homes, or buy new cars, your home isn’t going to do you much good.  So when the mortgage broker calls and tells you can take equity out of your house by refinancing, hang up!  There’s nothing wrong with refinancing to lower your monthly payment and create additional savings.  However, you want equity to build up in your house; it is another source of retirement savings.  When you approach retirement, you will be able to tap the equity in your home by down-sizing or remaining in your home and taking a reverse mortgage.

If you save 10% or 15% of your income over long periods of time, then you can adopt a moderate or conservative asset allocation, which will shield you from the devastation that seems to occur every 5 to 7 years when the financial markets undergo one of their convulsions.  Asset allocation is the third or fourth most important retirement question and should be used to protect the buying power of your savings.  When you retire, you want to make sure that inflation hasn’t ravaged your hard earned savings – that’s what asset allocation is really all about.

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