The 5 Most Common Ways People Derail Their Retirement
The following is an excerpt from Emily Guy Birken's new book The 5 Years Before You Retire
When I was a child, I struggled with perfectionist tendencies and would get very angry with myself whenever I made a mistake. My mother used to reassure me by saying, "Everyone makes mistakes. That's why they put erasers on pencils." (See also: What You Can Learn From Our Financial Mistakes)
The unfortunate truth, though, is that some mistakes are much costlier than others, and we don't always get a do-over if we've screwed up. This can definitely be the case with making financial mistakes in planning your retirement — not to mention making mistakes once you've taken the retirement plunge. With limited time to recover from mistakes and the high consequences you face if you make one, it's clearly better to avoid retirement planning mistakes than try to recover from them.
There are some common ways that pre-retirees and retirees can stumble in the path to retirement, but just because many retirees fall victim to these common mistakes doesn't mean that you will. Everyone may make mistakes, but having the necessary foreknowledge to avoid these pitfalls can keep you from jeopardizing the retirement you want and deserve. (See also: Small Mistakes That Can Ruin Your Finances)
The following are five of the ten most common ways people can derail their own retirement:
Retirement Pitfall #1: Relying on Factors Outside of Your Control
While you might roll your eyes at someone who talks dreamily of the day his ship will come in and what he'll do with all that imaginary wealth, near-retirees will often make the exact same mistake. They will make their plans for retirement contingent on things that they cannot control.
For instance, finance guru Dave Ramsey once suggested that the average investor can count on a 12 percent return on his or her investments. While I have a great deal of respect for Mr. Ramsey's advice on becoming debt-free, his suggestion that anyone can expect 12 percent investment returns is simply irresponsible. Ignoring where Ramsey got his particular numbers (since market returns are historically closer to 10 percent), all investors need to take to heart the fact that past returns are no guarantee of future results. (Everyone should have that piece of financial wisdom embroidered on a pillow, or even tattooed on an arm.) Counting on a particular return to have the retirement you dream of means you've given up control over your own future. You cannot control the market — although you have complete control over how much you save and how much you spend. (See also: Reduce Credit Limits to Manage Spending)
Similarly, expecting to inherit money from a wealthy relative is foolhardy as a retirement scheme. Not only do wealthy relatives have the disconcerting habit of living what seems like forever, but they also sometimes fall for beautiful young things or idealistic causes in their final years — meaning they change their wills.
Every individual who plans to retire needs to recognize that she or he can only count on her or his own actions. Markets are volatile, promises can be reneged, and nothing is guaranteed. But you have complete control over your money and your plans, and you can change both as needed. (See also: Essential Truths for a Successful Retirement)
Retirement Pitfall #2: Overreacting to Market Volatility
For many of us, the market crash of 2008 made it seem as though the most prudent thing to do was cash out our portfolios and bury the money in the back yard. It's a perfectly natural reaction to such a sudden market downturn. When we see our investments take a huge hit basically overnight, it's difficult to stop our inner Chicken Littles from freaking out over the sky falling.(See also: Stress-Free Retirement Investing)
But jumping at every downturn is the way both madness and lost revenue lie. The market tends to return around 10 percent over time. That means investors need to weather downturns and trust that the market will recover. Otherwise, getting out of the game after a loss means that you have made a temporary loss a permanent one.
According to Joni Clark, Chief Investment Officer for asset management firm Loring Ward, "everyone who converted to cash in 2008 — especially after the market dropped — locked in those losses, which meant they also missed the market surges that took place in 2009. Investors who sold out of the equity market for the safety of cash in early March may have locked in losses of close to 25% for the year-to-date 2009, and may have missed out on a 58% stock market rebound (as measured by the S&P 500 Index)."
Our tendency to overreact to losses in this way is a symptom of the cognitive bias called loss aversion. This weird quirk of our brains makes us work harder to avoid a loss than to earn a gain. For whatever reason, our brains are wired to make us feel losses more keenly than we enjoy gains. That's why I avoid looking at my investments more often than quarterly. Paying daily, weekly, or monthly attention to your portfolio can tempt you to get out of investments that are only taking a temporary dip. By limiting your exposure to the information — and with the help of your financial adviser — you can make more rational decisions. (See also: Mutual Fund Basics)
The other side of the market overreaction coin is continuing to sit on investments that are going gangbusters in the hopes that they will keep going up and up. While it is always possible to liquidate investments before they reach their peak, the greater likelihood is that waiting will only result in losses. It doesn't feel particularly good to kick yourself after either of those scenarios — but wouldn't it hurt more to lose money because you sat on an investment until the price started falling?
Retirement Pitfall #3: Inactivity
After reading through the last pitfall, you may be thinking that the best thing to do when managing your investments is absolutely nothing. That will keep you from meddling with investments when they need time to grow.
While this is an excellent goal, having a set-it-and-forget-it mindset about your retirement investment vehicles also means you will miss out on growth. If you never review your investment strategy or regularly rebalance your portfolio, you could find yourself looking back on years of lost opportunities. (See also: Common Investing Mistakes)
The best way to maximize your investment opportunities is to diversify your assets and meet regularly with your financial adviser to rebalance your portfolio. Joni Clark's advice is specific on this point:
"Define your plan for diversifying, and then rebalance regularly, whether once a quarter, once every six months, or once a year. Sell the assets with the most growth to bring your portfolio back into alignment with your plan, and use that to meet your withdrawal requirements. This approach forces you to sell high, something everyone tries to do, but few actually accomplish."
This approach is not only crucial in the lead up to retirement, but it is also a necessary part of your post-retirement strategy. Being proactive and making savvy asset choices can ensure that your nest egg lasts for the long haul.
Retirement Pitfall #4: Retiring Without Your First Three Years' Income Set Aside
One of the distressing aspects of the 2008 market downturn was watching those who had planned to retire that year lose a huge portion of their nest egg just as they were ending their career. Those retirees found themselves in the unenviable position of either having to continue working past their target retirement date or having to figure out a way to cut their living expenses in order to stretch their reduced nest egg. (See also: How Much Money Will You Need to Retire?)
There is no way to predict the future, so it is entirely possible that anyone reading this book may find him or herself in a similar situation. However, rather than simply accept that your long-term investments might have to be sold at a terrible time, you can protect yourself by making sure you have created an early retirement bucket. (Chapter 3 of The Five Years Before You Retire offers a full explanation of the asset allocation or "bucket" method for retirement).
In short, rather than have all of your savings tied up in long-term investments up until the day you say sayonara to the office, you should have the equivalent of one to three years' worth of living expenses set aside in short-term and conservative assets, such as short-term bonds, money market funds, and cash equivalents. If you retire at the bottom of a market downturn, you have built in enough of a cushion to allow your long-term assets to recover without having to sell them at a time that will cripple your nest egg for the rest of your retirement.
Talk to your financial adviser now about creating such a short-term bucket, since you will want to start transferring assets a few years prior to your projected retirement date in order to be prepared for your first few years after retiring.
Retirement Pitfall #5: Taking a Loan from Your 401(k)
This is an enormous no-no at any time in your career, but it's a particularly disastrous mistake if you're within five years of your retirement. Money removed from your 401(k) is money that cannot grow (with compound interest!), even if you are able to pay it back relatively quickly. The lost time equals lost growth, which you cannot afford to waste. (See also: Boost Your Retirement Savings by Avoiding 401(k) Fees)
In addition, 401(k) loans are considered withdrawals — with the attendant 10 percent early-withdrawal penalty plus income taxes — if you lose or leave your job before paying it back. Add the fact that most 401(k) plans will not allow you to contribute money to the plan while you have an outstanding loan, and it's clear that this kind of loan is going to be extremely costly for you.
If you need a loan, it's far better to explore taking a home equity loan or borrowing from your insufferable brother than taking money from your own future. Yes, the interest on 401(k) loans tends to be low, and you are paying that interest to yourself. But the potential costs and risks are far too high, especially for those who are in their final years of work.
To see the other five ways that retirees are most likely to shoot themselves in the foot, refer to Chapter 12 of The 5 Years Before You Retire by Emily Guy Birken.