How to Plug the 3 Leaks That Can Sink Even the Best Retirement Plan
By now, most investors know that high investment fees can eat away at your returns — and nest egg — over time.
Those fees can really add up: An additional 1% management fee can be the difference between a $100,000 investment growing to more than $320,000 or less than $265,000 over 20 years.
Yet, as more people flock to low-fee funds and inexpensive investment advice — including robo-advisors and target-date funds — investors need to be mindful that there are other potential leaks in their portfolios.
“There are a lot of inefficiencies in money management, and in fact, those inefficiencies collectively are actually much more impactful on your long-term financial health than the fees that you pay for financial products,” says Matt Fellowes, CEO and founder of Washington, D.C. based investment advisory United Income.
In a report published earlier this year, Fellowes and his colleagues noted that while investment management costs for retail investors have dropped by more than 50% over the past 35 years, the benefits of lower prices may be undermined by other costs that aren't tied to fees. They include taxes, mismanagement of Social Security, and subpar investment returns.
United Income found — after analyzing 62 different retirement solutions and more than 26,000 potential combinations of future market returns — that reducing these portfolio leaks generated seven times more wealth in retirement for a typical retiree than would saving 1 percentage point on investment management fees.
Put another way: Investors who plug these other leaks have a 42% better chance of generating enough money for retirement than those who focus exclusively on minimizing fees.
Here are some of the biggest leaks retirement savers need to plug.
Mistake #1: Worrying too simplistically about risk.
Retirees and those on the verge of retirement have long been warned of the dangers of taking on too much investment risk; hence the old rule that your bond allocation should be equal to your age (so if you're 65, the old rule of thumb was that you keep 65% of your nest egg in fixed income and only 35% in stocks).
But betting too tentative can be just as detrimental to your long-term savings.
A better strategy: Don’t think of your retirement savings as one big pot of money. Instead, think of your nest egg as different piles of money, each meeting a specific spending need. And then match your risk tolerance with those specific needs.
For example, many retirees would benefit from breaking their savings into three buckets, one for basic living expenses, one for lifestyle spending, and one for long-term healthcare.
For most people, says Fellowes, risk tolerance will vary greatly by bucket.
While a low-risk strategy makes sense for covering food, shelter, healthcare and other basic needs, he notes, retirees tend to be more comfortable taking on risk for savings tied to lifestyle spending, such as vacations or dinners out. Meanwhile, many retirees will need to take on a little more risk for funds tied to long-term expense.
“People have relied on fairly simple rules of thumb to determine how much to save and how,” Fellowes says. It’s far better to think about your risk preferences for each of your different spending needs.
Mistake #2: Focusing on maximizing Social Security at the expense of savings
Waiting as long as possible to claim Social Security benefits is a savvy move for most people. Holding off until age 70 – as opposed to 62 – can effectively guarantee an annual return in the high single digits.
But there’s a catch: This strategy often only makes sense if delaying Social Security benefits doesn’t require dipping into your long-term savings. “Generally speaking, it's better to hold onto your savings, rather than wait to claim a higher Social Security benefit,” says Fellowes, with the caveat that this is too important an equation for retirees to rely on generalities.
A better strategy: Think about optimizing Social Security rather than maximizing it.
If you can hold off claiming Social Security without having to tap your savings, the strategy probably makes sense. If you’ll need to use some of your savings to do so, it’s a more complex calculation. Drawing down on your savings too early can be more detrimental than claiming Social Security sooner rather than later.
See how your monthly benefits vary depending on when you start, and then see what impact it will have on the longevity of your savings. “Some people should claim Social Security early, some people should claim it late, and some people should claim it right in the middle,” says Fellowes.
Mistake #3: Overlooking taxes when selling or tapping your accounts
Odds are you understand the benefits of saving as much as possible in tax-efficient savings vehicles, such as 401(k) plans or Individual Retirement Plans (IRAs). Yet, many savers don’t pay enough attention to how they can reduce taxes on the other side – when they sell holdings or withdraw money to fund retirement.
A better strategy: Improve your take-home retirement pay by being as tactical about how, when, and from where you unwind your savings.
Among other strategies, you can use tax-loss harvesting in taxable accounts, where you sell a losing security to realize the loss, which you can use to offset capital gains elsewhere in your portfolio, lowering your overall taxes.
You can use Roth IRAs when possible to draw down income, as money withdrawn from a Roth comes out tax free. And you can time your withdrawals to make sure you stay in the lowest tax bracket possible.
While technology has improved many aspects of investing and wealth management, the industry has only scratched the surface when it comes to optimizing taxes and other non-fee expenses. “There is a whole other frontier of savings,” says Fellowes, whose firm is building a software engine to optimize withdrawals for tax purposes.
“We’ve partially succeeded in driving down fees; the question is what comes next? And is that enough?”