Many workers face the prospect of a truly gruesome retirement, largely because they haven't put enough money aside to meet their expenses. But even if you've diligently saved for your retirement since the beginning of your career, one mistake you might be making could potentially jeopardize your entire nest egg.
False assumptions
In every financial plan for retirement, there are three major variables. First, you have to decide how much you can afford to save. Second, you have to invest that money appropriately. And finally, you have to have a sense of how much money you need after you retire, in order to maintain your desired standard of living and cover your expenses.
For the most part, people tend to focus on the first two of those factors throughout much of their careers. That makes sense; you're in complete control of how much you save and how you invest, whereas you may well have no clue how much money you'll need when you retire decades from now.
In lieu of a detailed analysis of their expected retirement expenses, many people use a simple rule of thumb to come up with an estimate. In particular, something as unsophisticated as taking 70% to 90% of your pre-retirement income forms the sole basis of what some choose as their retirement goal.
What do you really need?
The problem with that simple rule of thumb, unfortunately, is that it often bears no connection at all to what people need or want to spend after they retire. A recent study from the University of Michigan Retirement Research Center took a set of 7,700 households and tried to calculate how much income they really needed to cover their financial needs in retirement. It concluded that at most, only 15% of households should aim for the 65% and 90% income level, while nearly half can afford to save less than 65%.
Among other things, the study found that those who were not married could generally afford to save less than married couples. In addition, if you don't have kids, you can typically live on less in retirement than if you do.
At first, that sounds like great news. If you don't need to replace as much of your pre-retirement income, then you don't have to save as much. But if you've worked for years under the assumption that those rules of thumb actually worked, you may well have made serious mistakes that will be hard to recover from.
Aiming at the wrong target
Take an example. Say you have $300,000 set aside, and you plan to retire in 10 years. Based on your earnings and the assumption that you need to replace 80% of your pre-retirement income, you conclude that you'll need $1 million to retire comfortably. Since you need to make your money triple in a decade, you might make aggressive investment decisions like:
- Investing all or nearly all of your money in the stock market.
- Gravitating toward high-beta stocks such as Teck Resources
(NYSE:TCK) , Research In Motion(NASDAQ:RIMM) , and VMWare(NYSE:VMW) in an attempt to boost returns by taking on greater risk. - Failing to rebalance your portfolio in order to ride trends for longer periods.
Those bets might work out. But when they don't, they can put you in a world of hurt -- like they did to investors during last year's bear market.
Now consider what happens if it turns out that 80% is way off, and you only need 50% of your pre-retirement income, corresponding to a nest egg of just $625,000. Now that you only need to see your money roughly double -- an average annual rate of around 7.6% for the decade -- you can afford to be more conservative, by doing the following:
-
Diversifying your portfolio into bonds, commodities, real estate investments like Simon Property Group
(NYSE:SPG) , and other investments. - Investing in less volatile conservative stocks, such as Colgate Palmolive
(NYSE:CL) , ExxonMobil(NYSE:XOM) , and Kimberly Clark(NYSE:KMB) . - Monitoring your risk tolerance and rebalancing to keep it in line.
By having the freedom to take a safer route to retirement, you increase your chances of actually getting there.
Know what you need
Of course, the more you save, the bigger a cushion you'll have to handle unexpected surprises. But don't count on a rule of thumb for the most important decision of your financial life. Take the time to figure out exactly what you want in your retirement, and you'll get a much better sense of what you have to do to get there.