When it comes to a retirement plan, luck may have something to do with how well you do, how much money you have and whether you will outlive your cash. Of course, getting to retirement requires a little bit of good fortune as well.
Those who believe that retirement will be close to what they envision have had some sort of plan in place, either by default or by chance. An inheritance will certainly fall into this category, be it cash or property or even a business venture. If you have been fortunate enough to come into this sort of gifted nest egg, lucky you.
But luck can be something ingrained as well. The determination to see your mortgage through to the last payment, to not burden your finances with unwieldy debt and to have begun early as an investor set you apart from your peers. You have the benefit of knowing, to some degree what your net worth is in terms of equity. You will have several more options available to you when and if you need to exercise them.
Pension participants also fall into this category. While fewer Americans have these sorts of defined benefit plans (about 23%), those that do can expect a steady stream of income (even if the plan fails). Currently about a third of all retired Americans rely on pension income.
In what could be a throwback to post Depression era thinking, only about 20% of the people who are focused on the retirement believe the stock market is the way to get to where they are headed. Of all of the sources of income that people will tap as a way to grow retirement dollars over the course of career, the stock market is probably the best method to generate outsized income. On the flip side, the risk involved has soured any potential. That’s unfortunate.
The stock market, more specifically the use of stock mutual funds, even more specifically, the use of actively traded mutual funds and to a lesser degree, index funds, offer the single best way to make more money that you might have ever been able to do with any other method. Turning away from this risk is understandable.
Embracing it can really only be done if you come to these investments with some sort of financial order in the rest of your life. Risk needs to be tempered. For instance, it would be unwise to invest solely in the stock market if you are burdened with debt, have no financial emergency plan in place and are trying to play a game of catch-up for years of non-participation.
But then again, savings accounts and other ultra conservative investments such as CDs will not sustain you in the years after work. Annuities are not cost effective and although they offer an insurance product married to an investment product, it is far cheaper to buy them separately.
So what if you have ambled through life doing none of this – no savings, no investments, no pension, no equity – what are your options? Work and Social Security. It may not sound very appealing but polls are uncovering some scary statistics about these sources of retirement income. It is now believed that over a third of all Americans who are or will soon be retired are counting on SS for their retirement income.
And while work is always an option, few really see it as a sustainable one. About 20% of future retirees plan on doing some sort of work in retirement but dues to a variety of reasons (lack of available work, health) only 4% actually succeed in doing so.
The combination approach is the best way to wrangle any sort of retirement from what seems to be, at least in the near-term, a very sketchy possibility. As always, working on debt and your health play a major role in any success in retirement. These two free up a whole spectrum of possibilities.
Once those items are dealt with (improving one’s health and getting a plan in place to pay off what debt you have are long-term efforts), you should not ignore the potential in the stock market. If you have a defined contribution plan (401K) at work, participate with at least 5-6% of your pre-tax income. This will have little or no impact on your net income, allowing you to keep your debt reduction plan on track. If you don’t have a plan at work, find $25 a week, open a separate savings account that can be funded through payroll deductions and send the cash to an IRA. A harder option but no less important.
Once your debt is handled, build a savings account using the money you paid the debt off with. It may not help in retirement, but it will help should your life be derailed through job loss or injury or some other of life’s little mishaps. Those little mishaps need funding and your retirement shouldn’t be jeopardized as a result.
Retirement does require some luck and all of us have some. Some have more than others. But even as the old Swedish proverb suggests: “Luck never gives; it only lends”, you can help your ability to be lucky in retirement by being focused on believing it doesn’t exist.
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I agree with most of what you say except for one major disagreement: You say that actively managed mutual funds outperform index funds, when the opposite has been proven true over many years by many independent analysts. Given the extra management fees, transaction costs, additional taxes due to turnover, loads/commissions, and 12b-1 marketing costs coming out of your investment returns, it is a wonder that people still think active funds can do well. In fact, about 80% of all actively managed mutual funds do worse than passive index funds. It would be a 50/50 split, before fees, but those fancy suits, offices, and bonuses cost (you) money. Why 50/50? Why don’t more actively managed funds outperform the average? Simple math: the whole set of active and passive funds together define the average. Mutual fund manager are not competing against you, the small investor, they are competing against each other. As for the remaining 20% who outperform, the problem is that this set of funds is not the same from year to year. Good luck finding one that will outperform from one year to the next, never mind over the long term. Over longer time, 95% of active funds do worse than the lowest cost passive index funds. There is no way to pick the best 5% (purely lucky managers) in advance, unfortunately. regards,
Jerry
Thanks Jerry. My problem is that the comparisons are unfair. You can’t compare the two types of investments just because they play on the same type of field. Index fees are less expensive and those costs have been coming down in recent years. But not all of these passive indexes are inexpensive. I like index funds. I just think that if you are going to own them, do it outside of your 401(k), in a taxable account where the tax efficiency pays the greatest dividends. However, inside your 401(k) or tax-deferred portfolio, look for the 20% that do beat the index funds.
I’ve been writing about how these plans should be structured to net the best effect of this. If you were to invest in your tax-deferred plan up to 10% of your gross income and then switch to a taxable account, or perhaps a Roth IRA and fully fund it investing in index funds, and then return to the tax-deferred plan and invest to the maximum allowed, you would hedge the (largely unknown) tax implications in the future. So index funds have a role. I just think they should be used as part of the strategy; not the whole of it.