Introduction

The New Age of Retirement

When we think of retirement, many of us remember what it was like for our parents or grandparents. They probably worked most of their lives for the same company, and when they reached retirement, that company continued to take care of them in the form of a pension. The company had a board of directors who would decide how much to save and how to invest the pension fund in a way to produce a steady stream of income for the company’s retired workers.

That world is mostly a thing of the past. Today, each of us is responsible for our retirement. We not only need to save up for retirement, but we also must figure out how to invest those savings so they will last the rest of our lives. While many companies will match whatever you save in your 401(k) retirement account (up to a point, of course), the trustees of the retirement plan who used to take care of the investments for you now just decide which investments to put into the company’s 401(k) lineup of choices. It’s up to you to determine how much to save and where to put that money, both before you retire and after.

Some of the most important decisions of your life are centered on taking care of your retirement. In a sense, you are at sea in a boat all by yourself, and you have to plot your own course. You have to know what direction to sail in and how long it will take to get to your destination. You have to learn how to forecast the weather and gauge the wind. Most importantly, you have to manage all those little disruptions that arise during the trip—the unexpected squalls, the occasional rough seas, and the doldrums, when there is no wind to help you, and it feels like you’re going nowhere.

Challenges of Retirement

Retirement in the United States changed forever when Congress passed the Revenue Act of 1978, which created the first 401(k) plans. Two years later, the IRS gave employees a tax-free way to use salary deductions to fund their 401(k) plans. People loved this. They could transfer money from their gross pay to a retirement account and not have to pay any taxes on the income until years later when they retired and started withdrawing the funds.

Companies also loved 401(k) plans, which were cheaper and more predictable than defined benefit pension plans. Within a few years of the Revenue Act, many large companies switched from offering pension plans to making contributions to their employees’ 401(k) plans.

The US Department of Labor watched as that trend accelerated over the next several years. In 1980, for example, nearly a third of all Americans still had a defined benefit pension plan for their retirement and only one in twenty had one of the new 401(k) accounts. By 2010, the Department of Labor found that only about 2 percent of Americans had pensions and more than a third had a 401(k) plan as their primary source of funds for retirement. Nearly 80 percent of all US residents worked for an employer who offered a 401(k) plan. In just thirty years, the retirement landscape had changed dramatically.

The result is that today, if you’re fifty-five or so and have been saving for retirement throughout your career, you must decide how to invest those savings so that you have a steady income that covers all your needs after you leave the workforce. Retirement used to be simple: work hard for thirty or forty years, then pick up your gold watch and collect your pension check every month. Now, even in retirement, your work isn’t over. You still face difficult questions about how to nurture your nest egg so that it will continue to provide for you over the next thirty years or so.

That’s a tall order!

Myths about Retirement

To make matters even more challenging, many prospective retirees leave the workforce believing a number of myths about retirement. Let’s take a look at some of those mistaken beliefs.

I’ll only need about 70 percent of my preretirement income to live comfortably after retirement.

Well, maybe and maybe not. It all depends on your goals and objectives. Do you plan on traveling after retirement? Many people do. What about healthcare and medical expenses? These costs often increase for retirees, and you have to take them into consideration. You may still have a mortgage or a car payment to make. You still have to pay taxes on your income. While it’s true that many retirees learn to reduce their spending after retirement, not everyone can.

I won’t face any financial surprises after retirement.

What if you need a new roof? What if the car you just paid off breaks down? What if you suffer a major illness? Many people don’t take these challenges into consideration or plan ahead for them when thinking about retirement. Despite your detailed planning for the expenses you will face in retirement, unexpected expenses can arise and some of these expenses may be substantial.

Now that I’m retired, I can get conservative with my investments. I’m only going to live till I’m seventy, so I won’t need that much money.

The average life expectancy for Americans today is much greater than it was when your parents and grandparents retired. According to the Centers for Disease Control and Prevention, the life expectancy for an American in 1950 was sixty-eight years. Today, it’s seventy-nine—and higher in the United Kingdom and Canada (around eighty-two).

If you were going to live for only ten years after you retire, then, yes, you could be as conservative as you want, because you can eat into your principal and it’s not going to cause you any problems. Today, thanks to modern medicine and our own healthy habits, many of us will live for another twenty-five or thirty years after we retire. This means we will need an income that can outpace inflation and cover our financial needs during that time. Accomplishing this requires making wise investment decisions and keeping an eye on those investments.

It’s easier to start saving later in life after I’ve put the kids through college and paid off the house. That’s when I’ll start focusing on retirement.

The problem with this approach is that you miss out on twenty or thirty years of growth in the stock market. Saving and investing early—even if it’s just a small amount—will put you way ahead of someone who stops saving at thirty-five and then resumes after the kids are grown. Investing early allows you to reap the benefits of compound interest. Compounding is when you reinvest your earnings, allowing your initial investment to grow exponentially. This is why people like me always encourage young people to start saving and investing as early as possible!

I’ve saved $1 million in my 401(k) and I can retire early.

Most people don’t think of their 401(k) balance in spendable after-tax terms. Having $1 million set aside in a tax-advantaged plan is great, but the reality is that to spend any of that, you will have to pay taxes on the money first. That makes a million-dollar portfolio worth only $750,000 after tax (assuming a 25 percent tax rate). For many retirees, they overstate the real value of their (tax-deferred) retirement assets. Having a million in a 401(k) or IRA is not the same as having a million to spend.

My company will take care of my healthcare needs before my Social Security and Medicare kick in.

Many companies are moving away from offering ongoing healthcare. Even the companies that help early retirees are putting an increasing burden on the shoulders of former workers to cover a portion of that cost. This can represent a significant expense that eats into your savings in the years before you reach full retirement age and begin receiving Medicare benefits at age sixty-five.

Retirement planning is easy. I’ll just analyze my spending for one year and then set up my investments to cover my needs. I can set it and forget it.

It’s never that easy. The sequence of stock market returns varies significantly and has a major impact on your portfolio’s health. You have to pay attention and make adjustments depending on what the market does.

The S&P 500 returns about 10 percent on average, but the returns are often below that over an extended period, such as the first decade of the 2000s. If that decade occurred during the first ten years of your retirement, you would have started eating into your principal much sooner than someone who invested at a different time. To increase the odds you won’t run out of money, you would have had to cut back on your spending or do something else to make up for the meager returns. Taking the set-it-and-forget-it approach can produce a disastrous outcome when you least expect it.

I have enough saved to maintain my current lifestyle in retirement.

We will go into this more later, but inflation is the greatest threat to most retirees’ standard of living in retirement. For example, assuming just a 3 percent inflation rate, $70,000 annual spending in today’s dollars will require nearly $95,000 to buy the same level of goods and services ten years from now....