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Ignoring the Bear And Other Mistakes Retirees Make

A survey in USA Today once concluded that Americans' most deep-seated fear, after cancer and car wrecks, was running out of money during retirement. The angst is understandable since one of the most complicated financial feats Americans will ever tackle is making their cash last through retirement. Unfortunately, too many investors will find that they have failed even before they have started. I don't

A survey in USA Today once concluded that Americans' most deep-seated fear, after cancer and car wrecks, was running out of money during retirement. The angst is understandable since one of the most complicated financial feats Americans will ever tackle is making their cash last through retirement.

Unfortunately, too many investors will find that they have failed even before they have started. “I don't think there is a broker or money manager on earth who doesn't want to cry when a 53-year old comes in with $40,000 and says, ‘Do I have enough to retire?’” says Mike Gentile, an investment advisor at William Blair in Chicago. “It probably happens to brokers once a month.”

Advisors can greatly increase their clients' odds of success by steering them away from some of the most common — and damaging — retirement mistakes. Here are some of the biggies to avoid:

Mistake No. 1: Counting on steady returns

Many people take the past and project it into the future. They might assume, for instance, that the equity portion of their portfolios will return, on average, 10 percent annually and bonds a little more than 5 percent. While these figures seem reasonable based on average historic returns, your job is to knock these numbers out of clients' heads.

Here's why: When retirees assume their nest eggs will generate a constant return, they are more likely to drain their accounts too quickly. You can see how a retiree can get into trouble by looking at what could have happened to an aggressive portfolio that's divided between large-cap stocks (75 percent) and government bonds (25 percent). During a period from 1926 to 2004, this portfolio roughly generated a 10 percent return, while inflation averaged 3 percent. Looking back at those figures, an investor might assume that he could safely withdraw 7 percent from a $1 million portfolio and adjust that $70,000 by inflation each year.

When you are withdrawing money, however, historic averages are irrelevant, says Larry Swedroe, the director of research at Buckingham Asset Management, an investment advisory firm in St. Louis. What matters is the pattern of yearly returns, particularly in the early stages of retirement. Say an investor had retired in 1972 and withdrew 7 percent a year; with yearly inflation adjustments, he'd have gone broke by the end of 1982. The reason, of course, is that his portfolio would have hit a buzz saw — the vicious bear market of 1973-1974 when the S&P 500 plummeted by 40 percent.

Mistake No. 2: Draining the account too quickly

Because none of us know when the next bear market will strike, retirees need to act as if a grizzly is already in their driveway ripping through trash cans. If retirees want their money to last three decades, many financial experts suggest that they should only withdraw 4 percent of their cash during the first year of retirement. For the second year, they'd adjust the initial amount of cash they took out by the inflation rate. And they'd continue doing that each year for the rest of their lives.

William Bengen, a certified financial planner in El Cajon, Calif., illustrated the soundness of this withdrawal approach more than a decade ago in a critically acclaimed study that was published in the Journal of Financial Planning. He examined what would have happened to portfolios during some of the most ferocious bear markets in modern times, from the Great Depression through the tech-bubble implosion. “If you take out no more than 4 percent a year,” Bengen says, “that should give you absolute certainty that the money will last 30 years.”

Bengen's original study was considered such a breakthrough that the Journal reprinted the study in its March 2004 issue in celebration of the publication's 25th anniversary. You can read the study, Determining Withdrawal Rates Using Historical Data, by visiting the magazine's online archives at

Wealthy retirees have to worry about market risk. Many wealthy retirees want to leave money behind for their offspring, but, to do so, they're going to have be able to stomach holding equities — and taking a somewhat aggressive posture, at that. Using Monte Carlo simulations, T. Rowe Price researchers recently looked at what would happen to four model portfolios, each containing $500,000, which all relied upon an initial 4.5 percent withdrawal. The most aggressive portfolio was invested 80 percent in stocks and 20 percent in bonds. The most conservative was 20 percent in stocks, 50 percent in bonds and 30 percent in short-term bonds. While all four portfolios enjoyed a very good chance of lasting 30 years, the median ending balances were dramatically different. The final tally for the stock-heavy portfolio was $495,000 in current dollars versus $180,000 for the most timid portfolio.

Mistake No. 3: Forgetting about taxes

Lots of investors believe that taxes are going to be far less of a nuisance once they retire. But your affluent clients could be among the unlucky souls who are stuck paying taxes on 50 percent, or even 85 percent, of their Social Security checks. The newly retired also tend to overlook the huge tax bill they face as they drain their retirement portfolio. A couple could have $1 million invested in sheltered accounts, but if they're in, say, the 25 percent tax bracket, the after-tax value of this cash is just $750,000. And it could shrink still more when the state rattles its tin cup.

Conventional wisdom suggests that your clients siphon the contents of their taxable accounts first. The maximum 15 percent tax rate they face on dividends and realized profits in taxable accounts is obviously far lower than the tax damage they'll generate when draining a retirement account. Clients would typically cash in their retirement accounts next. The withdrawals are taxed as ordinary income, which tops out at 35 percent.

Accepting conventional wisdom, however, can create problems later. Suppose a couple taps their taxable accounts early in retirement, which leaves most of their remaining cash holed up in retirement accounts. Shortly after reaching the age of 70 1/2, retirees must begin taking their required minimum distributions from their sheltered accounts. These mandatory withdrawals can nudge retirees into higher tax brackets, as well as trigger taxes on their Social Security checks.

To avoid this tax trap, investors may wish to start withdrawing some retirement assets before reaching 70. They'll want to be careful that their withdrawals don't elevate them into a greater tax bracket. Obviously, it's best not to touch this cash. You may want to suggest that they divert this money into tax-managed mutual funds inside a taxable account.

Another option is using some of the cash to pay taxes to convert a traditional IRA into a Roth, which is a phenomenal gift to inherit. Not all retirees can qualify for a conversion, but more are eligible this year than ever before. The rules prohibit a Roth conversion if someone's modified gross adjusted income exceeds $100,000 during the year of the conversion. (Oddly enough, the same ceiling applies to singles and married couples.) In the past, a lot of elderly investors would have met this requirement except for one thing: They had to include their mandatory IRA withdrawals when calculating their income. The government no longer considers these distributions when calculating Roth conversions.

Mistake No. 4: Overlooking inflation

Think about this for a minute: With an inflation rate of 3 percent, the value of $100 drops to $76 after a decade. Wait 20 years and the value shrinks to a mere $56. While Social Security checks are indexed for inflation, most pensions aren't.

Retirees often like to invest in long-term bonds to minimize the risk of reinvesting when interest rates are lower, but the longer the bond term the greater the risk of inflation. One way to protect a retirement portfolio against inflation is to invest in Treasury Inflation Protected Securities (TIPS) and I Bonds. These securities provide a guaranteed real rate of return, and are great diversifiers because they are negatively correlated to stocks. And, of course, most retiree portfolios should also embrace stocks. “Even when you're 85,” says Igor Kroner, a certified financial planner at William Blair in Chicago, “you want to be exposed to equities because that's where the growth comes from.”

Mistake No. 5: Forgetting to tell the kids how valuable an inherited IRA is

After working so hard to amass a sizable nest egg, wouldn't your clients be horrified if much of their money got wiped out by taxes? This scenario, however, gets played out all the time when loved ones inherit IRAs. “There is a lot of incompetence when it comes to handling inherited IRAs,” observes Ed Slott, a CPA and the author of Parlay Your IRA Into a Family Fortune (Viking, 2005). People, who are lucky enough to inherit IRAs often don't appreciate what they've got so they cash them out, which can trigger horrific tax bills. If an heir resists the temptation to blow the money, however, the cash nestled inside an inherited IRA can potentially keep growing for decades. Even with the mandatory IRA withdrawals, an IRA can easily grow three to four times what it was worth when its original owner died.

To appreciate the beauty of an inherited IRA, you need to understand its potential. Slott provides this example: A 45-year-old woman inherits a $50,000 IRA from her mom. If she chooses to stretch her required withdrawals over the next 38.8 years, which is what the IRS says is her life expectancy, and the IRA grows at an average annual rate of 8 percent, she'd pull out $303,113 before the IRA is depleted. The value of an inherited IRA is even more stunning when someone receives a large IRA. If the daughter inherited a $500,000 IRA, she'd withdraw a whopping $3,031,136 before it was finally emptied. Now that's some gift.

How Much Can You Spend in Retirement

The table shows the estimated probability of maintaining several spending or withdrawal amounts throughout retirement, depending on the investor's asset allocation and time horizon. The analysis assumes pretax withdrawals from tax-deferred assets and can be applied for any size retirement portfolio.

20-Year Retirement Period
Initial Withdrawal Amount Stock/Bond Mix*
80/20 60/40 40/60 20/80
7% 56% 52% 44% 26%
6 74 75 75 71
5 89 92 95 97
4 97 99 99 99
25-Year Retirement Period
Initial Withdrawal Amount Stock/Bond Mix*
80/20 60/40 40/60 20/80
7% 39% 30% 17% 4%
6 57 53 44 25
5 77 78 78 73
4 91 94 97 98
30-Year Retirement Period
Initial Withdrawal Amount Stock/Bond Mix*
80/20 60/40 40/60 20/80
7% 28% 19% 7% 1%
6 45 38 24 7
5 65 63 57 40
4 84 87 89 89

* The following asset allocations include short-term bonds: 60/40 includes 60% stocks, 30% bonds and 10% short-term bonds; 40/60 includes 40% stocks, 40% bonds and 20% short-term bonds; and 20/80 is comprised of 20% stocks, 50% bonds and 30% short-term bonds.

Source: T. Rowe Price

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