Retirement Planning is not only about investments. Investments are one piece of the Retirement Planning puzzle. Last week at the Bauer College of Business at University of Houston I shared a presentation I call: Retirement Planning – Managing Retirement Risk with a “Three Bucket Strategy”. This strategy is valuable for anyone in the accumulation phase of Retirement Planning.
Retirement Planning Three Bucket Strategy Includes:
The bronze bucket contains a wide array of accounts, such as stocks, bonds, and real estate, for which we pay taxes before we invest and on income realized from the investments.
The silver bucket includes instruments that are tax deductible, like 401k, a 403b, or a traditional IRA. With these, we get a deduction today, and we defer taxes until later when we with- draw funds from the accounts.
The gold bucket contains tax-free instruments like the Roth IRA. This has the most potential for tax savings and significant income in the future.
This episode could be titled: Managing the Risk of Retirement Planning
Texas-Sized Tip of the Week: THE PERFECT INVESTMENT for Your Retirement Planning
Well, there may not actually be a “perfect” investment, but matching funds come as close as anything I’ve ever seen. Many companies offer to match money we put into retirement accounts, and that’s free money! It doubles your income immediately, and it will multiply your savings over time.
Sadly, I’ve known a number of people who didn’t take advantage of this incredible opportunity. If your employer offers it, do whatever you need to do to get the maximum you can get. You might not be able to afford the latest gadget for your computer every time a new one comes along, but you’ll have something far better: peace of mind that your future is looking good!
Retirement Planning and Investment Diversification
Only a few years ago, the collapse of Enron dominated the business news, but for some people I know, the national news was painfully personal. In the years just prior to the company’s col- lapse, the company urged employees to keep all their retirement funds in Enron stock. One of my clients realized that was a risk she wasn’t willing to take, but another client bought the company’s promises of long-term stability. Beth came to me a few months after the company filed bankruptcy. For all intents and purposes, Enron had ceased to exist, but she had a huge amount of money to invest. I asked, “How did you get out of there with all this money?”
She replied, “I saw the writing on the wall, so I took my money out of Enron stock well before it tanked, and I put it in other funds.” Today, Beth’s retirement account is doing quite well.
But Frank didn’t see the writing on the wall. He believed the officers who told him, “Don’t worry. Everything will be just fine.” In the heyday of the company, Frank had over $1 million in Enron stock in his retirement account. A few months later, he had nothing. The financial setback was too much for him. The pain and shame caused panic attacks, then a heart attack. Frank died as another ca- sualty of Enron’s financial mismanagement.
Diversification is a way to spread risk. My favorite illustration comes from my friend David Coney at Edward Jones. David taught me to illustrate diversification by talking about elevators. I tell the client he has a choice of two elevators. A single cable holds up one eleva- tor, and eight strong cables hold the other. The building, I tell the client, is 100 years old.
Then I ask, “Which elevator would you take to the top floor?”
This question often elicits a chuckle and a quick reply, “The one with lots of cables.”
The single cable may be strong for a long time, but if and when it ever breaks, people in the elevator will be in trouble. But if one of the eight cables on the other one breaks, the other cables can hold it very securely. This simple drawing illustrates the difference be- tween trusting in one financial product (that is, “putting all your eggs in one basket”) and having a diverse portfolio. This illustration also describes the benefits of mutual funds over individual stocks. In these funds, managers check the cables (individual stocks) in their diversified holdings, and replace those that aren’t performing well or have too much risk.
It’s sound, established, financial logic to avoid having too many assets in a single investment, but some executives, managers, and employees view their company’s stock like it’s their first-born child. For example, one man told me, “I’d never sell my company’s stock. I’d feel disloyal.” We talked further about the benefits of diversify- ing, and ultimately, logic prevailed. Some people, however, won’t budge. Their emotional investment in their pet stock is so strong that they simply can’t bring themselves to sell any portion of it.
Asset Allocation and Retirement Planning
The distribution of assets to balance risk and reward is the most important principle of investing. A little wisdom makes a huge dif- ference in the return on investment. A lady named Kimberly came to me, and she was visibly upset. Her husband Ed had an IRA with $100,000, but he had kept it in a money market at .5% during five years the market had gained 10 to 16% each year. They were both about 35 years old. Dozens of times, she had suggested that he move his money to more productive instruments, and finally, he agreed to meet with me. I explained asset allocation, and they both felt much more comfortable about investing the money. They understood infla- tion was a big risk to their future, but properly allocating their assets in the market would help them balance risk and return. When I showed them the math, they were stunned. Here’s what I explained: If they kept that $100,000 in the money market (cash) account at .5% from age 35 to age 65, the account would be worth only $116,140. By investing their 401k into a diversified family of mutual funds with an expected return of 8% compounded annually, the amount would jump to $1,006,265! Kimberley and Ed almost fought each other to see who would sign the papers to move the funds.
Asset allocation needs to factor in these elements:
- Your risk tolerance, which determines how aggressive or conservative your investments will be,
- The time horizon for achieving your stated goals, such as col- lege education for a child in 2 years and retirement in 35 years, and
- The market dynamics of cash, bonds, equities, and real estate and their relationship to one another to maximize returns while minimizing risk.
Three factors determine the performance of your retirement portfolio: asset allocation, the selection of assets, and market timing. In a ten-year study of ninety-one large corporate pension plans in the United States, the authors of an article in Financial Analysts Journal found that 94% of performance was determined by asset allocation. Investment selection accounted for 4%, and market timing was responsible for only 2%.
*B.G.P. Brinson, B.D. Singer, and G.I. Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal (January/February, 1986).
The metaphor I use to explain asset allocation is balancing a tire. When I was a mechanic, and a customer came to my shop be- cause the car was shaking, the problem was almost always that a tire was out of balance, sometimes caused by a small bump of rub- ber from uneven wear. Even a seemingly small imbalance of a quarter of an ounce could cause the tire to shake violently at high speeds. I applied a weight to counter-balance the wheel. We checked it on the balancing machine to be sure it ran smoothly, put it back on the car, and the customer was ready to go.
Asset allocation balances the portfolio, so the assets run smoothly toward your goals. Sometimes people only need to make small adjustments, but often they need to make major changes in the dis- tribution of assets. Some people are so risk-averse that they want to keep all their money in cash, and they want to divide it up so they stay under the FDIC limits in each institution. But this strategy only limits risk in the immediate future. Returns on cash accounts don’t even keep pace with inflation, so there is no opportunity for asset appreciation and they actually increase their long-term risk.
Retirement Planning and Dollar cost averaging
Many of us are tempted to wait for a windfall—winning the lottery or a big inheritance from Aunt Phoebe—before we even start to invest. Our hopes are high because we’ve heard stories of people who hit it big, but those stories are in the news because they’re so rare, not because they’re commonplace. The best way to develop a substantial nest egg is to develop the discipline of putting money into a fund every month—no excuses. The market will go up or down, but our funds continue to grow slowly and steadily. I know people who began putting as little as $25 a month into an invest- ment, and over time, they’ve accumulated a substantial amount of money. When they were young, they had every reason to put off investing because they could easily use that $25 for dinner and a movie. But they were committed to save and invest, even if it was a small amount. When they got promotions and raises, they increased the amount they put away each month.
To explain the benefit of regular investing, I use the illustration of a farmer who invests each month in his favorite commodity: cat- tle. Farmer Joe calls me and wants to invest $100 each month. When he begins, the market for cattle is near an all-time high. Cattle sell for $100 each. He wonders if this is the right time to invest, but he needs more cattle. The first month, he can buy only one cow. In the second month, the price of cattle goes down to $50, so he buys two. The third month, the price goes to $25, so he buys four that month. And in the fourth month, the price of cattle plummets to a low: $20 each. At that point he calls me and says, “Hey bucko, what have you gotten me into? Cattle are $20 a head! I bought all these cattle at high prices, and the bottom has dropped out of the market! I’m going to sell them all and cut my losses.”
I tell him confidently, “Farmer Joe, the market is very low right now. You were paying $100 a head four months ago. You needed cattle, didn’t you? Has that changed? No? So why are you upset? This is the best time to buy cattle, not sell. Hang in there. You’re in great shape to benefit from this phase of the cycle.”
Farmer Joe bites his lip and decides to trust me. The next month, the price creeps up to $25 again. Farmer Joe buys four head. The next month, the price has risen to $50, so he buys two, and the next month, the price of cattle is back up to its high of $100, and he buys only one head. At that point, Farmer Joe decides to sell. During those seven months, he bought nineteen cows for a total of $700. They’re worth $1900, yielding a net profit of $1200, and the price of cattle never rose above $100 a head. Farmer Joe’s only regret was that he didn’t sell his tractor and buy more cattle when they were $20 each.