Funding your retirement is a big financial obligation that no one can escape. How big? While other expenses like paying for college education or a home are also large, they aren’t necessarily in the same league. Why? Because buying a home or paying for a family member’s education isn’t something we necessarily have to do. On the other hand, all of us at some point in the future will stop working and retire. And those of us that have saved an adequate sum of money will be in good shape whereas those who haven’t won’t.
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While it may come as bad news to some, even those who have been diligent savers throughout the years, carefully investing their money, they could face catastrophic situations that derail their ability to live a comfortable retirement. Let’s examine a few of them.
Having the Wrong Asset Mix
Getting the wrong investment or asset mix inside your IRA, 401(k), 403(b), 457, or other retirement plan is a common mistake. How does this happen?
Although many retirement plans use target-date retirement funds as a default choice, many of these generic products are far too aggressive in their equity exposure as people reach their retirement target date. For example, the Vanguard Target Retirement 2020 fund (Nasdaq:VTWNX) has almost 58% of its exposure to stocks. While it’s true people retiring in the year 2020 may live another 20 to 30 years, a stock market decline of 20% or more would inflict serious damage. Market declines of this magnitude (20% or more) have occurred in the past and they will occur again in the future. And investors who have been lulled into complacency by rising stock prices along with excessive exposure to stocks will pay dearly.
At the opposite spectrum of people who overdose on risk taking, are the people who invest too conservatively. Because of the lower returns associated with conservative investments like short-term bonds (SHY) and cash, people who park too much of their money in these type of low reward assets face the dire prospect of having the buying power of their investment savings consumed by inflation (TIPS).
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Whether a person is too conservative or too aggressive, having the wrong asset or investment mix has the same counterproductive results of undermining a person’s retirement plan.
No Margin of Safety
The three cornerstones of a well-built investment portfolio are 1) a core, 2) non-core, and 3) a margin of safety. Each of these three parts plays a crucial (and different) role than the other part inside your investment portfolio. Generally, the core and non-core portion of your total investment portfolio will be geared toward growth and income. In contrast, your portfolio’s margin of safety is strictly kept for preserving the value of your money. Your portfolio’s margin of safety serves no other purpose but to give you a cushion and permanent form of insurance.
What are the appropriate characteristics of the assets to be used inside your portfolio’s margin of safety? First, they 1) they should not lose market value, 2) next, they should not have any market volatility, and 3) finally, the principal and income should be guaranteed. These prerequisites automatically rule out assets like gold (GLD) and bonds (BND), which are often incorrectly used as margin of safety assets. Because bonds and gold are both susceptible to market losses, they are unsatisfactory components for a person’s margin of safety.
The exact percentage of your portfolio earmarked for margin of safety is not guided or decided by present or future market conditions, but rather by your age, financial circumstances, and your level of risk tolerance. To help you calculate the correct amount of your total portfolio that should be designated for margin of safety, text 33444 and type “4Safety” to receive your complimentary margin of safety worksheet from ETFguide.
Finally, employing asset allocation and diversification are not satisfactory substitutions for investing without a margin of safety. Likewise, being a long-term investor does not make you prudent if you’re investing without an adequate margin of safety
Higher Taxes in the Future
If you took an informal survey, most Americans would probably agree that tax rates are really high and can’t go much higher than they already are. Yet, if we study U.S. tax rates, we get a better of picture of the truth about income taxes.
Back in 1913 when the U.S. government first began taxing people’s earnings, the federal tax rate on income was just 1%. By 1943, the highest marginal tax rate in the nation had skyrocketed to 94% and any portion of income that exceeded $200,000 was taxed at those ungodly rates. By the 1970s, U.S. citizens earning more than $200,000 were in slightly better shape, being taxed just 70% on anything earned above that $200,000 threshold. Today, the marginal rate at which top earning Americans are taxed at is 39.6%, which seems like a bargain compared to tax rates in previous decades.
Sadly, many Americans (and financial advisors) make the false assumption that people will be in a lower tax bracket after they retire in the future. It’s simply not true given the $20 trillion in national debt along with other unfunded financial obligations the U.S. government, on behalf of its people, has so generously assumed.
Back in 2008, the Congressional Budget Office estimated that lowest tax bracket would jump from 10% to 25% and the current 25% bracket would soar to 63%, while the very highest federal tax bracket would go from 35% to 88%. How did they come up with these frightening numbers? They did this based upon the assumption that no changes in Social Security, Medicare, or Medicaid benefits would be made.
Tax hikes of double or more are not unprecedented, especially with the fiscal reality (and crisis) facing America’s bankrupt entitlement programs. And the reality of higher future taxes will catch a lot of retirees and their financial advisors by nasty surprise. The only solution is to aggressively attack the problem by identifying the right balance of money kept inside your taxable, tax-deferred, and tax-free buckets. Simply stashing away as much money as possible inside your IRA, 401(k), or other tax-deferred retirement plans will not solve the problem.
Even the best designed retirement plans face many perilous risks. And while having the wrong asset mix, investing without an adequate margin of safety, and failure to address the threat of higher future taxes are big league problems, they are just three among the many hazards that threaten your retirement security.