The road to retirement is a minefield. Your investment returns may be lower than you’d expected. Inflation could be higher. You can pick the wrong asset classes. All sorts of things can go wrong.
Most investors know the biggest mistakes even if they find them hard to avoid, like saving too little, putting all eggs in one basket, counting on big returns, betting with borrowed money, reaching for big yields or plundering the 401(k) for toys.
But there’s another level of mistakes not quite so obvious — missteps you can make by not knowing enough or paying too little attention. Here are some of the second-tier missteps mentioned most often by financial advisors.
Setting and forgetting
The biggest retirement mistake of all is not investing. So it’s a good thing that many small investors have followed professional money-management advice and bought mutual funds, exchange-traded funds and target-date funds and then wisely refrained from moving in and out with every change in the market. But it is possible to take the “set it and forget it” approach too far, says Matt Gellene, head of the financial center at Merrill Edge, an online investing service at Merrill Lynch.
“Often, employer-based retirement plans allow you to make your retirement contributions or investments automatic, so you’ll be able to invest and save without even thinking about it,” he said. But it’s a mistake not to get in there and make changes, like rebalancing when one asset class becomes too big or small — an exercise often conducted annually by investors — or forgetting to adjust when your situation changes.
“As you get older, consider job changes, salary increases and lifestyle changes as an opportunity to evaluate your savings plan and how much you’re contributing to your retirement,” Gellene said.
Confusing price with value
A fallen stock price looks like a bargain and makes it easier to amass a lot of shares, but it doesn’t mean you’re getting a steal, noted Brian Thomas, chief investment officer of AG Asset Advisory in Los Angeles.
“This is a classic fallacy,” Thomas said. It’s tied to what he called the “anchoring bias” of incorrectly viewing the low price — relative to the higher price the stock used to trade at — as an indication of a value stock opportunity. “A $50 stock that went to $5 lost half its value three times while falling and can do it again,” he said.
It doesn’t matter where a stock has been but where it is going. And that is based on the company’s products and services, management quality, regulatory environment — and a dose of luck. Figuring a stock’s prospects takes a lot more than seeing it at a new low.
Poorly managing taxes
The same investment can be a winner in one type of account, not so good in another. So Andrew Westlin, a planner at robo-advisor Betterment, recommends thinking carefully about what to own in a taxable account versus a 401(k), IRA or Roth IRA or Roth 401(k).
In a taxable account, interest and dividends are taxed the year they are received, and profits on investments that are sold are taxed the year of the transaction. Different rates apply to each type of income or gain. In a traditional IRA and traditional 401(k), taxes on interest, dividends and sales profits are postponed until money is withdrawn, and then all are taxed as income. In a Roth IRA or Roth 401(k), nothing is taxed, though many investors do not qualify for a Roth IRA account.
This means the same investment can be taxed more in one type of account than in another. A stock that provides most of its returns through gains in share price, for instance, could have profits taxed at the 15 percent long-term capital gains rate if held in a taxable account, but the same profits might be subject to an income-tax rate of 22 percent to 37 percent in a traditional IRA or 401(k), or no tax in either type of Roth.
Similar considerations surround dividend earnings, especially for the retiree who plans to spend them rather than reinvest. For most investors, dividends are taxed at 15 percent in taxable accounts, but at rates as high as 37 percent in traditional IRAs and traditional 401(k) plans.
The investor’s income-tax bracket is a factor as well. The lower the investor’s income, the smaller the difference between the capital gains rate in a taxable account and the income-tax rates in the retirement accounts. That can reduce the benefit of using one type of account over another. Also, the investor should think about how the income-tax rate may go up or down over the years as income rises and falls. While most people expect income to fall as retirement progresses, experts say that’s not necessarily the case if investments do well or a big inheritance arrives.
No one knows how the tax laws may change, so most planners assume current rules will continue. Generally, it is better to pay tax in years your bracket is lower, when you are young and poor or old and thrifty, rather than in your big earning years in middle age. Obviously, tax on investments is a tricky matter, which is why advisors recommend giving it plenty of attention as early as possible.
“Understanding your current and future tax bracket can help you save money on taxes and open up more planning opportunities in the future,” Westlin said.
Not anticipating expenses
How much will you spend on food, shelter and clothing after you quit work? Not only do many people fail to add these up, many have no clear budget for travel, entertainment and health care, experts said.
Assuming you will just live on whatever you have or that retirement will be a permanent spending spree could lead to bad decisions when investing, like being either too risky or too conservative.
“Generally, investment experts say that you should expect to need between 65 percent and 85 percent of your pre-retirement income each year during retirement,” said Kelli Click, president of Strata Trust Company, a retirement-plan administrator in Texas.
But individual cases can vary widely, especially where health-care costs come in. “It’s best to plan this out several years before you retire to make sure you’re covering all the bases,” Click said.
Treating the retirement calculators as gospel
No battle plan survives first contact with the enemy, as the old saying goes. Today many advisors use Monte Carlo simulations — calculators that can run thousands of scenarios with different combinations of returns for various assets — to produce a probability that a nest egg will last to, say, age 90.
But although the computer runs use a range of investment returns, they are typically based on past patterns, and that doesn’t account for investor behavior.
“Individual investors do not earn market returns,” said Jerome Golden, president at Golden Retirement in New York City. “Various studies show that investors do not stay in the market at all times,” he said, referring to the widespread habit of bailing out when the market dips and missing the rebound by staying out too long. As a result, typical investors earn 1 percent to 4 percent less than the market average each year, undermining the benefit of compounding — the process by which investment gains increase as a function of length of time in the market.
Golden said future taxes also are very hard to estimate accurately and that a plan can be upended if the retiree lives longer than expected.
“Killing the investor off at age 90 [in the plan] ignores the steepest part of the expense curve, because of dramatic increases in unreimbursed medical and caregiver costs after age 90,” he said.