4 Things You Need To Know To Improve Your Retirement Prospects
Research like this recent study from the Wharton School’s Pension Research Council shows that the more financially savvy you are, the more likely you are to save diligently and invest sensibly for retirement. But contrary to the impression you might get from some financial literacy tests, you don’t have to be a financial whiz kid or have the acumen of a Warren Buffett to make smart money decisions. In fact, if you follow these four key tenets of retirement-planning success—or what I like to call the “Core Four”—you’ll have pretty much all the financial knowledge you need to significantly improve your odds of achieving a happy and secure post-career life.
1. Saving discipline trumps investing skill. Many people think that superior investing is the surest route to retirement success. But as I’ve explained in a previous column, that’s a misconception. Sure, investing is important, and you’ll clearly end up with a larger nest egg—or increase the odds that you won’t outlive your savings in retirement—if your investments earn, say, 8% annually rather than 6%. But the investment gains you earn are pretty much dictated by what the financial markets deliver. Once you’re investing sensibly and stashing your savings in low-cost diversified portfolio of stocks and bonds, the only way you can boost returns is by taking on more risk—i.e., investing more heavily in stocks or focusing on more aggressive investments. And if you do that, you increase the volatility of portfolio and make it more vulnerable to bear markets and other setbacks. Which means that shooting for higher gains might boost the eventual size of your nest egg—or the effort could backfire, leaving you with a smaller savings stash.
By contrast, the relationship between saving and the size of your nest egg is simpler and more direct: the more you save, the larger your nest egg will be, whatever your investments may earn. If anything, the amount you save will play an even larger role in determining how well you’ll live retirement given today’s low yields and the likelihood that future investment returns will be much lower than in the past. To see for yourself how your retirement prospects might improve by saving more vs. investing more aggressively, you can go to this retirement income calculator and run scenarios with different savings rates and varying mixes of stocks and bonds.
2. It pays to be passive. You would think that with all the brainy investment pros out there investing millions of dollars on research and devoting all their energy to picking superior investments that it would be a cinch finding funds that consistently beat the market. But that’s not the case. According to Standard & Poor’s most recent index vs. active scorecard, more than 80% of funds that invest in large-company stocks underperformed the Standard & Poor’s 500 index over both the five and 10 years to December 31. Funds specializing in small- and mid-cap stocks fared much the same.
Which is why rather than trying to identify actively managed funds that may or may not rank at the top of the performance charts over a given period, you’re much better off entrusting most, if not all, of your retirement savings to “passive” investments, or stock and bond index funds that track, rather than try to beat, their market indexes. Aside from performance that consistently ranks them ahead of most actively managed funds, index funds have another advantage: you know exactly what you’ll get—i.e, the stocks that make up the benchmark the fund is designed to track. So you don’t have to worry about a manager concentrating a huge portion of his portfolio in a particular stock or industry or moving aggressively into high-octane stocks in pursuit of market-beating gains. This aspect of index funds, their predictability, makes them good building blocks for creating a retirement portfolio.
You’re also better off taking a passive approach when creating that portfolio and divvying up your money between stocks and bonds. Rather than engaging in the futile exercise of tilting your investment mix to stocks when it appears the market is ready to surge and to bonds if it seems poised to tank, you should settle on a stocks-bonds mix that reflects your tolerance for risk and, aside from periodic rebalancing, largely leave it alone regardless of what’s going on in the market. For help in setting a stock-bonds blend that gives you an acceptable tradeoff between long-term growth potential and short-term protection from market setbacks, complete this risk tolerance-asset allocation questionnaire.
3. Focus on cutting expenses more than boosting returns. I can’t guarantee that sticking to low-cost funds and ETFs will earn you the highest return on your retirement savings. But there’s enough research out there linking low expenses and superior performance to suggest that it makes sense to rein in costs as much as possible. For example, this May, 2016 Morningstar white paper titled “The Predictive Power of Fees” found that low-expense funds tend to outperform their higher-cost counterparts and noted that “the expense ratio is the most proven predictor of future fund returns.” Similarly, a recent study from the Boston College Center on Retirement Research concluded that higher fees most likely account for the fact that 401(k)s and IRAs tend to underperform professionally managed pension plans.
The easiest way to reduce the amount you pay in investment management fees is to stick to low-cost index funds and ETFs, many of which charge charge less than 0.20% a year in annual expenses. But you can also search for funds with low fees by going to Morningstar’s Fund Screener. To see just how much varying expense ratios can affect the value of your savings over long periods of time, try Bankrate.com’s Mutual Fund Fees calculator. If you’re paying a financial adviser to help you prepare for retirement, you’ll also want to make sure you’re not overpaying there as well, since any money you shell out in fees can ultimately have an impact on how large your nest egg might grow and how long it might last.
4. A little humility can pay big dividends. Human nature being what it is, there are going to be times in your life when you’ll feel a powerful urge to boost your retirement prospects by buying some hot new fund or ETF, investing in the next supposed growth area (organic foods, the marijuana biz) or perhaps by abandoning your long-term investing strategy and going more heavily into stocks (or bonds) because you’re convinced the market is about to surge (or nosedive).
Resist that impulse. Too often we convince ourselves that we know more than we actually do. Witness how many times over the past few years—the Brexit episode being the most recent example—that pundits predicted the imminent demise of this bull market, only to see it climb to new highs.
Confidence is great. Without it, we couldn’t motivate ourselves to save and invest for the future. But overconfidence is dangerous. It gives us the false impression that we’re in control and that we can foretell what the future holds. So as you plan your course to and through retirement, stay humble and avoid overconfidence. The more you remain aware of the limitations of your knowledge and abilities, the more prudently you’ll be able to plan and invest in an inherently uncertain world. (7/27/16)
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at firstname.lastname@example.org. You can tweet Walter at @RealDealRetire.