Common Retirement Investment Mistakes

Economic theory and logic tell us that we cannot reliably predict either stock-price movements or overall economic performance. Retirement investment strategy should focus instead on eliminating avoidable mistakes. Some of these are common enough to deserve special mention.

Failure to Allocate Assets Properly

Careful academic studies have shown that variation in investment performance is due primarily to distribution of assets among categories rather than selection of particular assets within categories. Orthodox financial planning dictates dividing the portfolio into asset categories, then allocating funds to those categories according to the risk tolerance, goals, and age of the client. “Growth assets” are allocated primarily to individual stocks, mutual funds, or variable annuities; “liquid assets” go to demand deposits or money-market accounts; “conservative” or “secure assets” go to CDs or government notes, “income-earning assets” go to bonds or fixed annuities.

Suppose that a worker invests $100,000, 60% of his or her portfolio, in mutual funds. One year later, the investment loses 40% of its value. Was this a mistake? If the worker was 25 at the time of the investment, no. Youth is the right time to concentrate on growth investing, and there is ample time to earn the money back over a working lifetime. Indeed, if the worker is making continuing investments, he or she may make the money back off the low-priced shares purchased during the period of declining value. If the worker was 60, yes; a 60% investment in growth-oriented equities so close to retirement was almost certainly wrong. This decline in value may be irreparably harmful to the worker’s wealth.

Notice that nothing was said about whether the funds in question were good or bad, or who was managing them. That is the difference between asset allocation and the active management with which most investors are familiar.

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An Example of Asset Allocation: Company Stock

Many workers are heavily invested in the stock of the company that employs them. Is this a case of “putting all your eggs in one basket?” Not necessarily. In youth and young adulthood, it is appropriate to orient investment toward growth, e.g., toward equities. Some successful portfolio managers, such as the legendary Peter Lynch, onetime head of Fidelity Magellan, urge average investors to invest where they have special knowledge. (Notice that the emphasis here is not on emotional loyalty to one’s company, but rather on the personal knowledge of its outstanding attributes.) While diversification is still a sound principle at any stage of investing, a disproportionate investment in company stock is not, ipso facto, erroneous.

Fast forward to the worker’s retirement day. He or she is still heavily invested in the company’s stock. Indeed, the company’s success and compounding of investment gains have increased the proportion of the worker’s portfolio comprised by company stock. If the worker has not already done so, now is the time to begin divesting the portfolio of that stock.

Failure to do this is one of the all-time leading retirement-investment mistakes. At least two factors make this divestment difficult. There is the emotional tie between worker and company, which may persist even after retirement. There is also the momentum caused by past investment success, which has an insidious effect on the worker’s thinking. The temptation to treat company success as permanent flies in the face of historical experience, as well as sound investment principles. A working life may last thirty or forty years; the company that can sustain solid growth longer than this without suffering precipitous decline is rare indeed.

The worker’s status has changed dramatically. He or she is now preoccupied with income and security of principal, not growth. Company stock almost certainly cannot produce the necessary income to sustain retirement, since tax law has distorted the payout policies of U.S. companies away from dividends and toward retained earnings. One serious market decline (or company-specific reverse) can reduce the worker’s wealth irreparably.

One reasonable approach is to purchase an immediate life annuity with some or all of the proceeds of the company stock at retirement. Alternatively, one might begin withdrawing funds from company stock a decade or so before retirement and placing them in a deferred annuity, set to begin distributions at retirement. Bond investments are also a reasonable choice in retirement; normally, this would entail purchase of individual securities rather than bond funds. Each of these strategies, or a combination of them, would provide the worker with the needed income while bolstering the security of his or her portfolio.

Taking Bad Financial Advice

One approach to retirement investment is to manage your own money. Another approach is to hire a good financial advisor to manage your money. Either of these approaches can work well. A third approach that rarely works well is to refuse to delegate the responsibility for managing your money to a professional but to purchase products from salespeople.

According to many estimates, a dismayingly-large fraction of all variable annuities are held inside IRAs or other tax-advantaged accounts. Many of the holders are retired investors who were persuaded by company representatives to make these purchases. The representatives made sizable sums of money from sales commissions and fees resulting from the variable annuity sales. Sometimes the variable annuities replaced other annuities, causing the holders to incur significant surrender charges. Other times the variable annuities replaced mutual funds, despite the fact that variable annuity subaccounts are functionally equivalent to mutual funds but with higher fees.

This is a contender for the title of “leading retirement investment mistake.” The ultimate cause of the mistake was the fact that the interests of the salesperson and the investor were misaligned. The salesperson had a strong vested interest in selling the investor the variable annuity product, but no comparable interest in serving the investor’s best financial interest. One remedy for this problem is for the investor to take financial advice only from people with a fiduciary obligation to him or her.

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Carelessness in Handling of Rollovers

Tax-advantaged retirement accounts offer tremendous advantages in the accumulation of wealth for retirement. One of their disadvantages is the myriad of rules and regulations governing their use. Some of the most vexatious are those affecting withdrawals and transfers of funds into and out of the accounts. Consider the following all-too-common example.

A worker reaches retirement and separates service from his or her company. Wishing to maintain control of retirement-plan funds for investment purposes, the worker withdraws the money in his or her 401(k) account for the purpose of depositing it in a self-directed IRA. Unfortunately, by taking personal control of the funds, the worker has technically effected a retirement-plan withdrawal and becomes subject to current-year taxation on the full amount of the withdrawal, as well as possible penalties (if the worker has not yet reached age 59 ½).

IRS rules allow 60 days after withdrawal from the 401(k) for deposit of the money into another tax-advantaged account. Once this time has elapsed, the worker is deemed to have taken “constructive receipt” of the funds, thus triggering a taxable event and possible penalties.

The safest way to avoid taking constructive receipt of funds is not to receive them in the first place. Transfer the money directly from one account to the other, allowing either your financial advisor or a company representative on one end or the other to handle the transaction. They will not send the money to you but rather to the address of record for the company or trustee of the account into which the money is to be deposited. Unfortunately, some companies release 401(k) funds only to the employee at his or her address of record; now you have no choice but to beat the 60-day deadline for rolling over the money.

Technically, the IRS distinguishes between a rollover (in which you take temporary possession of the funds, ideally for no more than 60 days) and a direct transfer (a “trustee to trustee” transaction where the funds travel between financial institutions, not to you, and the 60-day rule never becomes pertinent). You are limited to no more than one rollover every 12 months, but can make an unlimited number of direct transfers.

Failure to Insure Against Disaster

Of all retirement investment mistakes, this is perhaps the most excusable. It refers to a situation where the world falls down around the investor’s shoulders. Hyperinflation on a Weimar-Republic or banana-republic scale, worldwide depression, nuclear war or environmental calamity, collapse of the day-to-day operations of a modern economy – all these can fairly be characterized as disasters. For the most part, insurance companies view such things as uninsurable “acts of God.” How, then, to insure against them?

Ownership of assets that traditionally hold their value even in the face of disaster is the only way. The classic disaster-insurance asset is gold. Gold does not earn interest and is somewhat difficult to acquire. Its long-run rate of return is anything but spectacular. Yet it does hold its value, or even increase it, in the face of adversity.

People hold assets in order to obtain growth in value, income, liquidity, and security. Because gold ranks high only in terms of security, it should comprise at most 5% of the total portfolio.

Summary

Successful retirement investing is achieved by avoiding mistakes rather than by picking the particular assets that earn the highest returns. Certain mistakes occur so frequently as to deserve special mention. Among these are the failure to allocate assets in accordance with the investor’s preferences and age, the failure to diversify holdings of company stock at or near retirement, the proclivity to follow bad financial advice, carelessness in handling rollovers, and the failure to insure against disaster. Each of these mistakes can be avoided by following basic principles of financial economics or legal rules.

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