NAPFA - National Associations Of Financial Advisors

Retirement Myths and Truths
John Henry Low

Retirement Investing: Exposing the Myths

By John Henry Low

 
We know, we know. When it comes to retirement planning, you have heard it all before. But are you so sure that your retirement planning is current with today's investment markets?

Times have changed, and so have investing principles. Many current investment practices were learned in the 1970s, an inflationary period and a heyday for stock and bond brokers. But today, technology has arrived, rationalization and globalization are key words, and investment realities have shifted in kind. We are living longer, retiring earlier, and relying less on traditional savings vehicles and more on ourselves. All of these factors lead to some material changes in the way we save and in the investment principles that we learned long ago.

So why is investing for our own retirement more crucial than ever? To begin, life expectancies well into the 80s mean we face retirement spans of 20 years or more. We are also retiring earlier, forfeiting income for leisure, and relying less on traditional retirement savings vehicles such as Social Security and pensions.

Look at the facts:
• You probably need 75 percent of your current salary to retire.
· Social Security nationally accounts for about 18 percent of retirement income.
· Once you hit your earnings cap, Social Security will contribute relatively less to your retirement.
· Earnings account for 27 percent of retirement income.
· Retirement savings and personal investments account for another 43 percent.

Traditional retirement savings vehicles are falling short. Social Security will probably still exist in the future, but contributors can count on reduced benefits and longer waiting periods. As it stands now, Social Security payouts will exceed incoming monies by the year 2020. Pensions are getting rarer.

Inheritance can be a great windfall, but the median inheritance is only about $30,000 per person and can quickly be depleted in unforeseen medical bills. While 401(k) plans are still a great source of savings for most people, annual contributions are limited, and many people underutilize them by not investing the maximum allowable, or investing in their company's stock or in conservative investments for "safety." 

So our future financial security increasingly depends on the investment decisions that we make today. But many of us don't invest wisely. Below are six common fallacies regarding retirement investing.

Myth 1: Bonds are the best retirement savings vehicle.
For some people, they used to be. Many of us remember our fathers and grandfathers touting the safety and soundness of long-term government bonds. We were taught that bonds provided interest income to live on and that they were "safe," characterized by low volatility, which meant that the price of bonds didn't vary greatly with changes in the economy or other investments.

All quite true until 1979 when the picture changed dramatically. Why?  After the collapse of the gold standard in 1972, the Federal Reserve (the one body that has more power to affect our investments than any other) struggled with its focus. Should it target unemployment, inflation, or growth, and how should those targets be achieved?

But everything changed in 1979, when the Fed came under the leadership of Paul Volcker. After years of oil shocks and high inflation rates, monetary policy at the Fed began to encourage price stability. At first, Volcker targeted money sup-ply to control inflation. But by 1982, he realized that the supply of money was increasingly difficult to measure, and switched his focus to targeting interest rates. Either way, interest rates soon went into double digits, and investing has never been the same.

This new approach worked well; high interest rates soon slowed the economy enough to reduce inflation. The country had a new monetary policy that is even more relevant today with the Fed under the leadership of Alan Greenspan, a stalwart inflation fighter whose focus is keeping inflation at 3 percent or less. (Interestingly enough, inflation control has yet to be an official mandate of the Fed.) With the Fed manipulating interest rates to control inflation, the price of bonds has fluctuated more frequently and dramatically than ever before.

Fact: The volatility of bonds has increased substantially as a direct result of this change in Federal Reserve monetary policy. This means that bond prices fluctuate more rapidly and widely than ever before and could result in larger losses. With such price fluctuations, the opportunity costs of holding a long-term bond can be greater. (The opposite is true for stocks, whose steady growth has minimized their relative volatility over time.)

Myth 2: Bonds perform better than stocks over the long run.
Sorry, but no. Stocks have outperformed bonds in eight out of the last nine previous decades. While it is historically true that stocks will experience a loss about every three years or so, the longer you invest in equities, the more likely you are to experience solid returns. Your investment time horizon is among the most important determinants in the allocation of your portfolio. Since 1926, for example, there has never been a 15-year period in which the S&P 500 has lost money. And the differences in return can be dramatic. For the period 1926 through 1993, the average compound annual total return of the S&P 500 was 10.3 percent (12.4 percent for small-cap stocks) versus only 5.6 percent for long-term corporate bonds and even less for intermediate-term bonds.  But if your time horizon is only three to five years, equities may not work for you. Stick with money market investments, short-term bonds and low-volatility equities.

Fact: Stocks perform better than bonds over the long run; however, they are more volatile on the short-run. Your investment time horizon and risk tolerance should determine what type of investments to use.

Myth 3: Buying individual bonds is best.
Unless you have a lot of time on your hands, a high-speed computer, and are well-versed in econometric modeling, we think not. Most investors are not aware of the dramatic impact that even small movements in interest rates have on bond values. And even fewer of us really appreciate the degree of this impact when considering the term of our bonds. Take, for example, a $1,000 bond paying a 6 percent coupon. A 1 percent increase in interest rates, results in a 1.8 percent loss in the market value of a two-year bond but a 10.6 percent loss for a 20-year bond. The opposite is true for falling rates, of course. A 1 per-cent decline in rates leads to a 1.9 per-cent increase in the market value of a two-year bond, and 15.5 percent increase for a 20-year bond.

Interest rates have been at historical lows, and we wouldn't bet on rates falling further. Remember, rising or falling interest rates will not only dramatically affect the market value of your bonds but will also affect what types and maturities of bonds to hold going forward.  Cost is another factor. Thinly traded or illiquid bonds, such as many municipal bonds, can carry spreads or implicit trading commissions as high as 5 percent.

Fact: Few of us have the time or expertise to accurately "shift" the maturity structure of our bond holdings to capture the benefits of falling rates and monitor credit quality to avoid losses. Bonds are an important part of any retirement plan, but buying individual bonds may not be the best strategy. It is generally better to use a good bond mutual fund and leave the maturity shifting to the experts. You have the added benefit of being diversified among a large number of bonds with varying maturities. With over 7,500 mutual funds offered today, you can find one to meet almost any investment criteria.

Myth 4: Return is all that really matters.
Were it only so. Many of us overlook the impacts of inflation, taxes, commissions, and fees. When targeting retirement income, inflation must be taken into account. Even the current low annual inflation rate of 3 percent over a 20-year period means that more than half of your savings are eaten up in inflation (i.e., after 20 years, $1 is worth only 43 cents). Taxes can eat away 30 percent to 40 percent of your investment return. Keep tax considerations in mind when making investment choices, and seek expert tax advice if you fall into a high tax bracket. Don't forget to factor in the costs of investing (e.g., brokerage commissions, fees and loads). Make sure that returns justify fees. For example, $10,000 invested in a no-load mutual fund with a 10 percent return yields $11,000. The same $10,000 invested in a 5 percent load-fund with the same return yields $10,450 because the load is paid up front.

Fact: Inflation, taxes, and fees can go a long way toward eroding your retirement income goals. Make sure you take inflation into account when targeting your retirement income. Always consult with a tax expert when setting up your retirement plan and when starting to draw from it. Be aware of how much you are paying in fees and commissions. Alternative investments may be less expensive.

Myth 5: A successful investment plan doesn't touch principal.
Not necessarily. Limiting yourself to income-based investments such as Treasury bonds means only that you will be earning less on your money. For example, starting with $100,000 you could have bought a 20-year bond yielding 6 percent per year to earn $6,000 annually. Alternatively, if you had invested $100,000 in the S&P 500 in the bull market of the past 10 years, after deducting $6,000 per year, your portfolio would now be worth almost $300,000.

Fact: Earning higher returns over the long-run, in many cases, makes it worth-while to "dip" into principal.

Myth 6: When it comes to investing for retirement, the safer the better.
Not even close. Because our retirement savings are so crucial to our futures, we often fall into the trap of thinking it is best to invest in traditional "safe" alternatives when actually quite the opposite may be true. Leaving your retirement savings in money market accounts or bank certificates of deposit earning 4 percent to 5 percent will barely keep you ahead of inflation, let alone inflation and taxes. And don't forget that interest rates can fall, leaving you with less income than you had planned. Actually, cash has been "king" (or the best investment choice of the year) in only 7 out of the past 70 years. And even in those years, it earned 4 percent to 6 percent at best.

Fact: With a time horizon of 15 to 20 years, invest in a well-diversified portfolio, emphasizing equities (domestic; international; growth; value; large-, mid-and small cap), bonds, and cash. Mutual funds are a great alternative for diversification and risk reduction. Know your risk tolerance and time horizon, and invest appropriately. Don't hesitate to call a professional if you need help in structuring or restructuring your investments. Your future financial security is too important to neglect.

Reprinted with permission by the Senior Lawyers Division of the American Bar Association. Copyright © 1996 by Knickerbocker Advisors Inc. All rights reserved. No copies or reproductions may be made without the express permission of Knickerbocker Advisors Inc. Information contained herein is solely for informational purposes and was obtained from a variety of recognized sources believed to be reliable. However, we do not make any representations as to its accuracy or completeness.