Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair. — Sam Ewing, humorist
Retirees should be as concerned about investing their retirement nest eggs as they are about withdrawing from them— the 2008 market crash exacerbated these concerns and makes this issue even more critical.
Fortunately, Smart Investing before or during retirement is not difficult. While you'll hear lots of ballyhoo about the special investment needs of retirees, the basic investment rules— the Smart Investing rules— are the same for everyone, no matter what their age or stage of their investing lives.
In Chapter 5 and Appendix B, I provide recommended portfolios that will take the mystery out of this process. Before jumping in, we'll review in the chapters ahead some basic investing principles you need to understand.
Let's start with the most commonly overlooked one: inflation.
Inflation: The Natural Predator of Your Nest Egg
Retirees understandably worry about the stock market's gyrations. Who wouldn't, especially given the current unprecedented fiancial meltdown? But they don't spend nearly as much time fretting about inflation.
In recent years, inflation doesn't seem to have been much of an issue. For more than a decade, the nation's annual inflation rate has rarely inched above 3 percent. As 2009 began, economists were far more worried about deflation.
Yet even a seemingly innocuous inflation rate can flatten the cushion of a retiree's otherwise solid budget. When inflation is running at 3 percent, the value of $100 will plummet to $76 in just ten years. If you wait two decades, the value of that $100 is worth no more than $56.
It's easy to illustrate how destructive inflation can be if you lookat hypothetical portfolios of retirees from twenty or thirty years ago.Today's retirees can easily live that long or longer.
I used the inflation calculator from the federal Bureau of Labor Statisticsto see how much money a retiree would need today to matchthe buying power of an American who retired with a $500,000 nestegg twenty years ago. Thanks to inflation, today's retiree wouldrequire $924,695. (You can play with your own numbers at www.bls.gov/data/inflation_calculator.htm.)
The current crop of retirees will likely feel the pinch of inflationmore acutely because it is likely they will have to spend more on medicalcosts, which have been rising faster than inflation.
Unfortunately, the only inflation indexing that most retirees cancount on today is their Social Security checks, which provide anannual cost of living allowance.
Countless research has illustrated that conservative portfoliosrun the risk of running on fumes. One landmark study examinedwhat would happen if an investor withdrew 6 percent a year from anall- bond portfolio. The study concluded that the investor had only a 27percent chance of having anything left after thirty years.
As you contemplate how you're going to structure your portfolio inretirement, you'll want to plan to deal with inflation.
The solution— as hard as this might be to swallow in today's volatilemarkets— involves adding stocks to your portfolio. I'll discussexactly how you should do that in Part Two.
What's the Point?
If you don't fortify your portfolio against inflation, you're likelyto outlive your money.
The Investing Secret Your Broker Won't Tell You
Index funds have a large following among institutional investorssuch as pension funds and insurance companies. Ironically,one of the most vocal advocates of index funds forindividual investors is Warren Buffett, self-made billionaireand chairman of Berkshire Hathaway Inc. [who] madehis fortune through individual stock selection.
— Richard A. Ferri, CFA, author of All About Asset Allocation
Indexing can make you feel like an investing genius.
Here are the major benefits of indexing:
Let's take a look at these more closely.
Index funds make a simple promise: Everybody who indexes willearn market returns minus low transaction costs.
Here's an example: If the S&P 500 index (the popular benchmarkfor blue chip stocks) generated a yearly return of 9 percent, you couldcount on the Vanguard 500 Index Fund, the Fidelity Spartan 500 IndexFund, or some other large- cap index fund to produce a return that'salmost identical.
The goal of an index fund manager is to be a clone of a corresponding index.
When an index stumbles, so will its index fund. When the index isdoing well, so will the index fund. Over time, stocks and bonds of everysize and category have grown, which means index funds have too.
It is perfectly understandable if you're not impressed by "average"market returns. After all, it's far easier to tout the stellar returnsof carefully selected actively managed funds. Unfortunately, thesereturns are almost always ephemeral. An actively managed fund canenjoy a streak of phenomenal luck— but nearly all actively managedfunds eventually stumble. Their long-term (and even shorter- term)performance returns lag behind comparable index funds.
Why do proponents of actively managed funds struggle so muchagainst those average returns?
These stock jockeys eventually smack into a brick wall called the"efficient market." Think about it this way: Wall Street is transparent—any news about any stock quickly makes the rounds, and the stock isadjusted accordingly. Consequently, it's almost impossible for professionalsto outsmart all the other investors trying to beat the markets.
The difficulty of surpassing index returns on a sustained basis iseven harder than it appears, thanks to something called "survivorbias." Every year, a huge number of actively managed funds go out ofbusiness. During one recent five-year period, according to Standard & Poor's, more than one in four stock funds vanished. The funds thatdisappear are typically the ones with terrible performance statistics.Fund companies will often get rid of the embarrassing funds by mergingthem into more successful ones.
With the dead bodies hidden away, the remaining actively managedfunds look better than they deserve.
Low Cost and Lovin' It
Index funds are the cheapest game in town. The Vanguard 500Index Fund, which is the nation's most popular index fund, chargesshareholders just 0.15 percent to manage their assets. That means ifyou had $10,000 invested in the fund, your tab for the year would be apaltry $15. There are even cheaper class shares for larger investors. Fora new shareholder who invests at least $100,000 in the Vanguard 500Index, the cost would drop to 0.07 percent, or only $70 a year.
The typical mutual fund can easily charge ten times more than acomparable index fund. People don't appreciate that price gap, becausethe difference doesn't seem wide. A fund that charges 1.7 percentdoesn't seem like a porker compared to one that charges 0.07 percent.In reality, the gulf is huge.
Let's suppose you invested $50,000 in a stock index fund that charges0.20 percent in expenses, and your neighbor invested the same amountin an actively managed stock fund that charges 2 percent. Let's assumeyou both earned an annual 8 percent return before expenses.
A decade later, your index fund would be worth $105,964. The fundof the poor guy next door would be worth $89,542. Your neighbor'scost for holding this fund would have been $16,422.
Index funds hold more securities than actively managed funds. Bydiversifying the number of holdings, index funds reduce the risk ofhaving a concentrated position in a smaller number of stocks.
When judging mutual funds, investors look at total returns. But performance statistics can be misleading. When investments aren't sheltered in retirement accounts, after-tax returns are the key feature.
Taxes can mangle the returns of actively managed funds. Too many portfolio managers trade stocks with little regard for the tax consequences that are borne by the investor. Index funds are considered paragons of tax efficiency because there is little turnover in their portfolios.
John Bogle, the former head of the Vanguard Group, conducted a study that illustrated how devastating the tax bite can be for actively managed funds. Over a sixteen-year period, Bogle concluded that investors kept only 47 percent of the cumulative return of the average actively managed stock fund. Indexers kept 87 percent.
Can you afford to leave that much of your money on the table?
Minimal Cash Holdings
Large cash holdings reduce returns in a rising market. Index funds typically have less cash holdings than actively managed funds because they don't have to keep cash on hand to time the market. Index fund portfolios stay focused on meeting the returns of the index.
What's the Point?
Investors who index achieve superior returns.
Ten Golden Rules
Practicing the Golden Rule is not a sacrifice; it is an investment.
— Author unknown
The Ten Golden Rules that I've put forth here won't work for everyone, but they should be considered by all investors, regardless of your age, whether you are currently planning for retirement or are already retired.
Sometimes intelligent retirement planning can seem overwhelming. However, these basic rules are really quite easy to implement.
You now have the knowledge to do it. Don't let anyone cause you to stray from the path toward a successful retirement.
It appears that people’s biggest concern is that they will outlive their money. Other than robbing a bank, do you have one suggestion that will help pretty well anyone?
While much depends how much people save and how smartly they invest before and during retirement, I recommend getting a fixed annuity (also known as an immediate annuity) from one of the low cost providers like Vanguard or TIAA-CREF. With an immediate annuity, you give the insurance company a lump sum and they give you monthly, quarterly or yearly checks for the rest of your life or longer, at your option.
Who can people rely on for advice about saving for retirement?
An advisor whose focus is on asset allocation (the division of a portfolio between stocks, bonds and cash) and who recommends investing only in a globally diversified portfolio of low cost stock and bond index funds. Sadly, the vast majority of traditional brokers and financial advisors would be disqualified from consideration based on these criteria.
Many people’s portfolios were decimated by the market crash and they don’t think they can now afford to retire. What should they do?
Hard times require hard decisions. There is no magic bullet – as some investors duped by the likes of Bernie Madoff will now attest. But anyone can dramatically boost their retirement nest egg by working an additional three or four years. One study showed that these added years of employment increased retirement income by a staggering 25%.