This weekend, CNBC linked to a rather lengthy article summarizing an opinion that’s a bit interesting to contemplate, yet flawed in my opinion. Here’s the source article, but I’ll summarize.
The premise of the article is that it’s really the last few years of returns in your retirement savings that dictate your nest egg upon retirement. This is because early on you have less money saved and later on you have more. To delve in a little more deeply, they provide the following example. The article states:
Save and invest diligently for 30 years, then cross your fingers and pray your investments will double over the last decade before you retire.
Example from the article:
Consider the numbers for a 26-year-old who earns $40,000 annually, with a long-term savings target of $1 million.
To get there, she’s told to save 8 percent of her salary each year over her 40-year career. (We assumed an annual investment return of 7 percent, and 3 percent annual salary growth, to keep pace with inflation).
Yet after 31 years of diligent savings, her portfolio is worth just slightly more than $483,000.
To clear the $1 million mark, her portfolio essentially must double in the nine years before she retires, and the market must cooperate (unless she finds a way to travel back in time and significantly increase her savings).
Should the markets misbehave, however, delivering a mere 2 percent return over the 10 years before retirement (not all that hard to imagine, considering the return of a portfolio split between stock and bonds over the last decade), she falls short by about a third.Her portfolio would be worth only about $640,000.
Why This is Flawed?
At first glance, you might say, “OK, this example paints a scary picture, where yes in fact, this employee is in trouble assuming even 7% annual returns since a low return in the final years kills the whole retirement nest-egg target”. The problem with this example though, is that the example assumes a 2% return in the final 10 years. While this is theoretically possible, just like we saw with the prior lost decade in stocks, it goes completely contrary to assuming 7% long-run investment returns to begin with. It’s really something well under 7% over the full span which is a far cry from the 8-10% oft-cited returns (including dividends). So, not only is the initial long-run assumption lower than the actual returns we’ve seen historically (fine, so you’re being conservative), but then on top of that, the example bastardizes the actual 7% assumed over the 40 years.
See, if they wanted to paint this right, the initial return should have averaged something well over 7% so that the 2% earned in the final decade brought the total 40 year return BACK down to 7%. They’re basically using double-jeopardy to prove their point, so the point isn’t very strong.
How to Overcome Poor Returns Late in the Game:
If you are concerned however, about retiring in a year like 2011 where we saw the prior decade basically flat, there are a few key areas of focus:
Oversave: Easier said than done, but as evidenced in the example above, if you want to be very conservative and assume a lower-than-historical rate of return for equities and your portfolio in general, then you’ll need to save more than say, an assumption of 8% returns. This means starting early and sacrificing more than you’d like.
Go Aggressive Early: I’m a big proponent of taking on risk commensurate with time horizon, so I’m as aggressive as possible now, knowing I have decades to go until retirement. I’m close to 100% equities, trying to get plenty in emerging markets as well. I’ll increase my bond exposure as I get older, but for now, aside from the notion that they may have more downside risk than upside potential, they also tend to underperform equities in the long-run.
Diversify – For Real: Speaking of emerging markets, diversification doesn’t just mean holding a broad market fund like an S&P500 proxy is adequate diversification. There should be country diversification, asset class diversification, and if you can’t get it in your retirement fund, invest outside. For instance, I can’t get access to energy and metals in my retirement fund, so I invest through my traditional trading account.
Have a Plan for some Income in Retirement: While this may not be practical for everyone, chances are, there are some skills you developed during your working years that you could parlay into a reasonable side-income. Maybe it’s blogging, maybe it’s consulting, maybe it’s painting houses. Whatever it is, it’s good to know that should your nest-egg or fixed income fall short, you can bridge the gap with side income and still enjoy your retirement. This doesn’t have to mean you “never retire”, just that you can retire on your terms with the flexibility to earn extra income if needed. Start planning early though, as you don’t want to find out at 63 that you’re running short.