MONEY early retirement

The Most Important Move to Make If You Want to Retire Early

Small birdhouse
Michael Blann—Getty Images

Housing is the most dangerous expense for those seeking financial freedom. Here's what you can do to control those costs.

Looking to achieve financial independence and retire sooner? A top priority should be to control expenses—especially your major living expenses like housing, food, transportation, health care, and recreation. We’ll focus on the rest of these spending categories in future columns, but for now let’s take a look at housing—the single largest expense for many, and one that can all too easily sabotage your journey to financial freedom.

Housing-related decisions will impact your financial independence by years, if not decades. Homes are a downright dangerous expense variable, because price tags are high, leverage (borrowing) is usually required, and various financial “experts” with their own agendas are usually involved. And houses expose our vanities, tempting us to spend for the approval of others, instead of in our own best interests. Losses of tens of thousands of dollars are routine in real estate, and can completely derail your savings plan.

Even when you don’t suffer an outright loss, changing homes is expensive. I moved around in my 20’s, had few possessions, and rented, so the cost of relocating was minimal. Then I married, we bought our first house, and had a child. Our next move was punishing: We were forced to sell our house at a steep loss, and, because of all our new stuff, we had to hire professional movers for the first time. When we finally bought a house again, we stayed put for nearly 17 years. In retrospect, that long time in one place was an enormous help in growing our assets and retiring early.

How much does it cost to change homes? By the time you add up the costs of selling, relocating, buying again, and settling in, you can easily spend $20,000, or more. According to Zillow, closing costs to a home buyer run from 2% to 5% of the purchase price. The seller doesn’t have mortgage-related costs but is likely paying a realtor commission as high as 6% or 7%. Then there are moving costs, and the inevitable shakedown costs with any new home: painting, carpets and curtains, repairs, supplies and furnishings, and basic improvements to suit your lifestyle.

In short, changing homes is frightfully expensive, and will probably eat up most of the average family’s potential savings for several years running.

Of course there are scenarios like career moves, where you don’t have the luxury of staying in place. But anytime the choice to move is yours, stop and consider the expenses. The worst possible choice would be an optional move into a larger house that you don’t really need. You are taking on a big one-time expense, plus a bigger ongoing mortgage and maintenance obligation. If more space is truly necessary, consider instead modifying your current home: When our son reached the later teen years, we renovated a larger downstairs room so he could have more space.

Once you’re in your home, be smart about home improvement projects, especially those you can’t do cheaply yourself. Trying to create the “perfect” home is an uphill battle, at best. Borrowing to improve your home is an especially bad idea, in my opinion. You can spend vast sums of money without measurably improving your quality of life. And old assumptions about getting that money back when you sell are outdated. For 2014, Remodeling Magazine reports that the average cost-value ratio for 35 representative home improvement projects stood at just about 66%. In other words, you don’t make money when you sell: rather, you only get about two-thirds of your money back! Financially speaking, that’s a lousy investment.

Lastly, while there are situations where it makes sense, on paper, to hold a mortgage, for those truly dedicated to financial independence, the disadvantages of debt often outweigh the benefits. In general, pay off your mortgage as soon as possible. Using extra income to pay down a mortgage loan can be a solid investment in today’s low-return environment. We paid off our mortgage years before retiring, and the peace of mind was invaluable. Now, in retirement, we rent instead of own. It’s a flexible, economical, and low-hassle lifestyle.

In short, maintaining a home will be one of your largest life expenses. Pay careful attention to your housing decisions if you’re serious about financial freedom!

Darrow Kirkpatrick is a software engineer and author who lived frugally, invested successfully, and retired in 2011 at age 50. He writes regularly about saving, investing and retiring on his blog CanIRetireYet.com. This column appears monthly.

More from Darrow Kirkpatrick:

The Single Most Important Thing You Can Do to Achieve Financial Success

The One Retirement Question You Must Get Right

How to Figure Out Your Real Cost of Living in Retirement

Read next: 3 Little Mistakes That Can Sink Your Retirement

MONEY Ask the Expert

How Can I Save More?

Financial planning experts share easy ways to trick yourself into setting more money aside for your future.

MONEY retirement age

How to Know When It’s Time to Retire

Birthday candles
Fuse—Getty Images

I’ve long argued that one’s quality of life should be a principal factor in deciding when to retire. At the same time, however, financial considerations can’t be ignored. With this in mind, here are three rules of thumb to help you decide whether you’ve reached the perfect age to retire.

1. Have you saved enough money?

The “multiply by-25″ rule is a popular tool that retirement experts encourage people to use to estimate whether they’ve saved enough money to stop working and, at least hopefully, begin a life of leisure.

Here’s how it works: Multiply your desired annual income in retirement, less projected annual Social Security benefits, by 25. If your savings are greater than that, then you’re in good shape. If not, then you may not be financially ready to retire.

For example, let’s say that Bob and Mary Jane estimate they’ll spend $40,000 a year in retirement. Using the rule of 25, they’ll need savings of $1 million.

A slightly different iteration of this is the “multiply by-300″ rule. This is the same thing, but it focuses on months instead of years — that is, take your average monthly expenditures, minus your monthly Social Security check, and multiply that by 300.

If your savings are greater than that, then you’re all set. If not, then you might want to continue working for a few more years.

2. Will you have enough income?

This question is related to the first one, but it attacks the issue from a slightly different angle. As such, it also has its own rule of thumb: the 4% rule.

This rule holds that you can safely withdraw 4% from your portfolio every year and still be confident it will last through retirement. Thus, to determine if you’ll have enough income in retirement, multiply your portfolio by 4% and then add in your projected annual Social Security benefits — to learn one potential problem with this rule, click here.

If the sum of these two numbers is enough to cover your expenses, then you’re ready to retire. If not, then it may behoove you to put off retirement for a while longer, as doing so should allow your portfolio to continue growing. It will also give your Social Security benefits time to accrue delayed retirement credits.

3. Is your portfolio properly allocated?

Finally, determining if you’re ready to retire isn’t just about how much you’ve saved, it’s also about how your savings are allocated into various asset classes — namely, stocks and bonds.

To be ready for retirement, you want to make sure that your assets are invested in as safe of a way as possible. To do so, it’s smart to steer your portfolio increasingly toward fixed-income investments like bonds as you approach your desired retirement age.

Experts use the following rule to determine the proper allocation: “The percentage of your portfolio invested in bonds should equal your age.” Thus, if you’re 60 years old, then 60% of your portfolio should be in bonds and 40% in stocks. If you’re 55, then the split is 55% to 45%, respectively.

While this may seem like it has less to do with the timing of retirement than the former two rules, the reality is that it’s of equal importance. As my colleague Morgan Housel has discussed in the past, one of investors’ biggest mistakes is to underestimate the volatility in the stock market. According to Morgan’s research, stocks fall by an average of 10% once every 11 months.

Suffice it to say, a drop of this magnitude would have a material impact on both of the preceding rules, as a 10% decline in your stock holdings would equate to a much smaller income under the 4% rule and, as a corollary, it would call for a delayed retirement date under the multiply by-25 rule.

And the impact of this would be even more exaggerated if the lions’ share of your assets were still in stocks as opposed to bonds. Consequently, the culmination of your strategy to bring your portfolio into accord with this final rule is a key step in determining the perfect age at which you’re ready to pull the trigger and actually retire.

MONEY Budgeting

How to Keep Fantasy Football from Fouling Up Your Finances

Fantasy Football
How much does your weekend pastime cost you? iStock

Make sure your weekend hobby doesn't wreak havoc on your budget—or your marriage.

Allison Lodish used to be a huge football fan.

Her affection for the game evaporated when her husband got fixated on fantasy football, a leisure pursuit where participants draft their own dream teams and compete against each other, based on how those players fare.

Before she knew it, he was in three leagues of fantasy football. Then, it became 10. “It was crazy,” says the 41-year-old personal stylist from California’s Marin County.

Crazy not just in terms of time expended, but money. Since many fantasy leagues charge fees for entering, trading players, or picking up free agents, the sums involved can be substantial.

At the height of her husband’s involvement, the hobby was costing north of $1,000 a year, Lodish estimates.

Indeed, the fantasy game has plenty of fans, with more than 41 million players in North America, according to the Fantasy Sports Trade Association. That’s up from 27 million in 2009, with the typical player dropping $111 a year on the hobby, and others, far more.

In an era of stagnant incomes and rising prices, it’s no wonder some spouses are alarmed by the amounts involved. The average player spends more than eight hours a week perfecting his or her team, the trade group says.

So, is there a fix for the obsession?

Experts say the first steps toward resolving familial conflicts around a fantasy sport involve turning off the TV for a few minutes and not obsessively checking statistics. Then, start working through marital differences that can easily spiral out of control.

“You have to figure out the crux of the problem,” says Sharon Epperson, CNBC’s personal finance correspondent and author of a financial advice book for couples, The Big Payoff. “It may be about the money, or it may have nothing to do with that. It may be the amount of time being spent away from the spouse or the children that is really annoying the other person.”

If a partner feels neglected, or the cash involved is being drawn from other family pots, that is a problem, says Matthew Berry, ESPN’s senior fantasy analyst and author of Fantasy Life, which chronicles the exploding interest in the field.

“Everything in moderation,” he says. “I don’t think fantasy football is different from any other couples issue. It’s about communication, and understanding what’s important to the other person.”

Here are some tips that may safeguard the family budget, or your marriage, from an unchecked fantasy-football fetish:

Family needs come first

“I don’t think spending money on fantasy sports is a bad thing—as long as you can afford it,” says Epperson, herself a devoted Pittsburgh Steelers fan who grew up watching greats like Franco Harris and Lynn Swann.

But if that cash is being siphoned from other critical needs, it’s a guaranteed recipe for marital discord. So before you sign up for multiple fantasy leagues, get your other bases covered.

Epperson’s advice: Stay current on all monthly bills, save 20% of your income in long-term vehicles like 401(k)s, and another 10% in short-terms savings like a household emergency fund. Then you can set aside 10% of income for “fun money”—and that’s where your fantasy-sports budget needs to come from.

Avoid secrets

Everyone likes to spend a little time and money on personal passions, whether it’s fantasy sports or designer shoes. And that’s okay – unless that information is being hidden from your significant other.

“It’s only a big deal if you are not telling your spouse,” says Epperson. “That’s like loading up a credit-card that your spouse doesn’t know about. That’s financial infidelity, and that’s a big problem in marriages.”

Involve your partner

If your spouse pushes back against your fantasy-football interest, take it as a compliment: They want to spend more time with you. So here’s an elegant solution: Get them involved, if you can.

“My advice is always, ‘Try it, you’ll love it,'” says ESPN’s Berry. “My wife now plays in my fantasy league. That way, Sunday becomes a day you can spend together, instead of apart.”

Hand over the winnings

If your spouse has zero interest in fantasy sports, here’s a novel approach: Pledge that any cash you win will go directly into their bank account.

“That’s what I did with my wife originally,” says Berry. “Whatever I won, she got to spend. So when I won my league, she got a brand new purse. It worked out great. Nowadays, if I’m falling behind in third place or something, she tells me to get it together and start studying up.”

Still, the outcome may not always be so collegial.

Allison Lodish eventually set up a website for fellow fantasy-sports “widows” and ended up splitting with her husband.

“It should be a fun game that brings people together,” she says. “But if it’s driving people apart, that is where you need to take a hard look at it.”

MONEY Ask the Expert

How Smart Savers Choose Between a 401(k) or Roth IRA

140605_AskExpert_illo
Robert A. Di Ieso, Jr.

Q: My husband and I are in our middle 30s and both have good jobs in a professional field. We each make $60,000 a year. Should we be saving in our 401(k) plans, or contributing to a Roth IRA?

A: The answer, of course, is that you should be doing both—but not necessarily in equal amounts, and much depends on your expenses and how much you are able to sock away. Let’s look at some of the variables.

The first consideration is making certain both of you get the full amount of your employer’s matching 401(k) plan contributions. “Fill up the 401(k) bucket first,” says IRA expert Ed Slott, founder of IRAhelp.com. “That is free money and you shouldn’t leave any of it on the table.” In many 401(k) plans, companies kick in 50 cents for every $1 you save up to 6% of pay. If both of you are in such plans, you should each contribute $7,200 per year to your 401(k) plans to collect the $3,600 your employers will match. But don’t contribute more than that, and if you get no match, skip it entirely—for now. It’s time to move on to a Roth IRA.

A Roth IRA is a far different savings vehicle than a 401(k) plan. Having one will give you more flexibility in retirement. Your 401(k) plan is funded with pre-tax dollars that grow tax-deferred. You pay tax when you start taking distributions no later than your 71st year. A Roth IRA is funded with after-tax dollars that grow tax-free for the rest of your life and that of your spouse, and they have tax advantages for your heirs as well. You can also take early distributions of the principal that you contribute, without penalty or tax, should you run into a cash crunch. So after you have each maxed out your 401(k) match, shift to a Roth IRA. Each of you can save up to the $5,500 annual limit.

The downside of a Roth IRA is that you lose the immediate tax deduction that you get with a 401(k) contribution. Still, “you eliminate the uncertainty of what future tax rates may do to your retirement income plan,” says Slott. If tax rates go up, as many believe they must in the years ahead, your 401(k) savings will become a little less valuable. But your Roth IRA savings will be unaffected.

Once you have each saved $7,200 to get the company match of $3,600, and have also fully funded a Roth IRA to the tune of $5,500—congratulate one another. That comes to $16,300 each of annual savings, or a Herculean savings rate of 27%. Most experts advise saving at a 15% rate, and even higher when possible. If you still have more free cash to sock away, you can begin to put more in your 401(k) to get the additional tax deferral. But you should first consider opening a taxable brokerage account where you invest in stocks and stock mutual funds. After a one-year holding period these get taxed as a capital gain, currently a lower rate (15% to 20%) than the ordinary income rate that applies to your 401(k) distributions.

Do you have a personal finance question for our experts? Write toAskTheExpert@moneymail.com.

MONEY retirement planning

The Single Biggest Threat To Your Retirement

Mirror
Shawn Gearhart—Getty Images

You might think a stock market slump or a shaky economy pose the biggest danger to your retirement. But the biggest threat may be looking back at you in the mirror.

There’s no shortage of things that can jeopardize your retirement security. Market slumps, job layoffs, medical expenses, an unanticipated spike in inflation, unexpected financial obligations…the list goes on and on. But as scary as these threats may be, they don’t represent the biggest danger to your retirement security. That would be…

You.

Yes, that attractive devil staring back at you in the mirror every morning.

That’s not to say the other hazards I’ve mentioned can’t diminish your retirement prospects. They can. But the danger we ourselves pose to our retirement security can be more insidious if only because we’re not as likely to be aware of it.

So how, exactly, do we undermine our own retirement success? Here are the main ways, followed by advice on how you can limit self-inflicted damage.

*We have a fear of commitment. I’m not talking relationships here, but the difficulty we have in starting to plan for retirement and, more specifically, beginning a savings regimen early on and sticking with it throughout our career. The latest stats from the Bureau of Economic Analysis show that the U.S. savings rate today hovers just below 6% of disposable income, less than half where it stood in the early 1970s. Even among people earning $100,000 or more, only about a third contribute the max to their 401(k). This reluctance to save isn’t totally surprising. After all, our brains are hard-wired for immediate gratification. The sleek car or fancy duds we can have right now are more appealing to us than financial security down the road.

*We’re too emotional. Just when we should be thinking with our heads, we too often go with our guts. Prime example: When the markets are booming, we feel more ebullient, which makes us more apt to underestimate the risk in stocks and load up on them. After a crash, our ebullience turns to gloom, leading us to overestimate the risk we face and flee stocks for the short-term safety of bonds and cash.

*We don’t follow through. Even when we take the time and effort to come up with a coherent strategy, such as building a diversified portfolio of stocks and bonds that jibes with our appetite for risk, we then sabotage our efforts by failing to adhere to our plan. We know that different returns for different asset classes will knock our portfolio’s balance out of whack over time. Still, we don’t bother to periodically rebalance our holdings to bring them back to their proper proportions. Similarly, even if go to the trouble to go to a good online retirement calculator to figure out how much we need to save to have a decent shot at a secure retirement, we often fail to monitor our progress and make periodic adjustments. Retirement is a multi-decade journey. You can’t set your course once and go on autopilot for 30 years.

*We focus on the wrong things. Instead of focusing on the most important aspects of retirement planning—Am I saving enough? Do I have the right mix of stocks and bonds? How should my spouse and I coordinate claiming Social Security to get more in benefits?—we get mired in the weeds, poring over performance charts for the funds that have the highest returns or endlessly researching exotic new investments that purport to provide more diversification in our portfolios. News flash: In the long run, the single most important thing you can do to improve your retirement prospects is save more. If you focus first on that and then turn your attention to building a simple mix of low-cost stock and bond index funds, you’ll have laid the groundwork for a secure retirement.

Fortunately, it’s possible, if not to completely eliminate, then at least mitigate the threat we pose to ourselves when it comes to retirement planning. We do have a natural tendency to spend, but behavioral research shows that we may be more likely to save for the future if we feel some sort of link with our future selves. One way to establish that link is to check out the Face Retirement tool in RDR’s Retirement Toolbox, which uses age-morphing technology to “introduce” you to your future self. Once you’ve made that connection, you may find it easier to set aside resources today to help the you of tomorrow.

Similarly, you can prevent emotions from wreaking havoc with your retirement by adopting a more disciplined approach to planning. Writing down a savings target—10% to 15% is reasonable—will make you more likely to adhere to it than a mere mental note to yourself to try to put some money away. Sign up for your 401(k) plan and elect to have that target percentage deducted from your paycheck, and boom! You’re overcoming both the fear to commit and the failure to follow through. Set an annual date—your birthday, day after Thanksgiving, whenever—to rebalance your retirement portfolio and check your progress with an online retirement planning calculator, and you’re doing an even better job on the follow-through front

The reality is that today the onus is increasingly on you to provide for your security in retirement. So the more you’re able to turn yourself into an asset that enhances your future financial prospects rather than a threat that diminishes them, the more secure and enjoyable a retirement you’re likely to achieve.

Walter Updegrave is the editor of RealDealRetirement.com. He previously wrote the Ask the Expert column for MONEY and CNNMoney. You can reach him at walter@realdealretirement.com.

MONEY 401(k)s

Why Your 401(k) Is Missing $273,000

Egg with hole in it
Mats Silvan—Getty Images/Flickr Open

If the 401(k) system worked as advertised, the typical retiree would have $373,000, one study finds. The reality: $100,000.

It’s no secret that America’s 401(k) system has a few flaws. But a new paper from the Boston College Center for Retirement Research shows just how far the system may be falling short.

The research, based on triennial survey data collected by Federal Reserve economists, found that the typical 401(k) balance for middle-income Americans preretirees—those between 55 and 65—was just $100,000. Based on current annuity prices, that amount would give you a retirement income of only $500 a month, a sum that would be eroded each year by inflation. Since “the typical household holds virtually no financial assets outside of its 401(k),” as the study notes, the average 401(k) plan isn’t likely to provide much of a supplement to Social Security.

That’s not what was supposed to happen. If the 401(k) system had worked as well in reality as it did in theory, those same workers would have $373,000 saved, or $273,000 more, according the study.

To reach that figure, researchers assumed a middle-income worker who turned 60 in 2013 began saving in 1982, at age 29. The worker contributed 6% to his or her 401(k) while receiving a 3% company match and invested in a portfolio split evenly between stocks and bonds—all seemingly reasonable assumptions.

So what happened to that missing $273,000?

The answer is that 401(k) balances have been eroded by a combination of unnecessary fees, poor plan design, and bad—or perhaps just desperate—decisions by savers.

Here’s where the money went:

Screen Shot 2014-09-15 at 1.55.26 PM

Fees: As the Center’s illustration shows, a big chunk of that missing money, some $59,000, went to Wall Street. The study’s analysis was based on the average fee paid to portfolio managers who oversee 401(k) mutual funds. Clearly, fund managers need to be paid something. But 401(k) investors are almost certainly being charged too much. Across the 401(k) universe, the average stock fund investor hands over fees amounting to 0.74% a year to fund managers, largely because they’re invested in actively managed funds. By contrast, the average stock index fund costs just 0.12%. The upshot: Most of that $59,000 is unnecessary cost.

Withdrawals: Another $78,000 is lost to so-called leakage—essentially, investors yanking money out of the plan. The Center for Retirement Research cited another study by Vanguard Group, which found that on average Vanguard plans leaked about 1.2% of assets a year, although that figure may be low, since Vanguard tends to work with large plans with wealthier employees who are less likely to cash out. It’s difficult to tell why investors aren’t sticking with the program. But it appears that roughly half the time investors simply cash the money out, while about a quarter of the time they qualified for a “hardship withdrawal,” such as a medical or housing expense.

Inadequate saving: Finally, there’s the problem of investor behavior. Most workers don’t save enough, or make “intermittent” contributions. Others failed to sign up or lacked the opportunity to do so, especially earlier in their careers—the “immature” system problem. Congress attempted to boost savings rates with the 2006 Pension Protection Act, which made it easier for employers to default new workers into 401(k) plans. As a result, many young people entering the workforce today are enrolled automatically. But there is still room for improvement. Many plans start workers saving at just 3%, not the 6% or higher rate that would lead to a larger balance—perhaps as much as $373,000.

What to make of all this? It looks like Wall Street, workers themselves and the design of the 401(k) all share part of the blame. “Surely, the system could function more efficiently,” the Center’s study says. Hard to argue with that.

More on 401(k)s from MONEY’s Ultimate Retirement Guide:
Why Is a 401(k) Such a Good Deal?
How Much Should I Put in My 401(k)?
How Should I Invest My 401(k)?

MONEY Savings

Our Retirement Savings Crisis—and the Easy Solution

Skinny piggy bank
Barry Blackman—Tarhill Photos Inc./CORBIS

The numbers show we face a major savings shortfall. But there's a simple way out if we act now.

Data can be misleading. Mark Twain reminded us: “There are three kinds of lies: lies, damned lies and statistics.” Yet more often than not sets of numbers tell a compelling story, and that is the case with 29 charts recently compiled by Vox Media.

Start with this data point: the savings rate in the U.S. will be about 4.1% this year, which ranks 17th among 24 countries in the Organization for Economic Co-operation and Development. It’s a slight number next to savings rates like 13.1% in Switzerland and 9.9% in Germany. It’s also a shadow of the 10% or better savings rate we enjoyed in the U.S. 40 years ago. And consider this: Our savings rate is only this high now because of a renewed focus on putting money away and paying down debt since the Great Recession. It had been running at about 2.5% before the financial crisis.

This low savings rate explains at least part of our retirement savings crisis. Some 36% of workers have saved less than $1,000. That includes workers in their first year of full-time employment. So it’s not quite as bad as it sounds. Still, 69% have saved less than $50,000 and just 11% have saved more than $250,000.

Looking at folks already retired, the numbers don’t change much: 29% have saved less than $1,000 and 17% have saved more than $250,000. These are bleak readings. Experts estimate that you’ll need to bank eight to 12 times final pay in order to retire comfortably. If you peak at a salary of $75,000 a year, you will need a nest egg equal to $600,000 to $900,000.

The current generation of retirees has a big advantage that helps explain how they are getting by on so little savings: many collect a traditional defined-benefit pension, which guarantees lifetime income, in addition to Social Security. Three decades ago, 38% of private sector workers had such a pension while 17% had a defined-contribution plan like a 401(k). Those figures have reversed. Today, 14% have a traditional pension while 42% have a 401(k) or similar plan.

This means individuals are becoming increasingly responsible for their own retirement security. Yet we are doing little to prepare them. Financial concepts are not widely taught in schools in the U.S., where 15-year-olds recently tested in the middle of the pack for financial literacy—behind Latvia and Poland, and more importantly behind nations like Australia and New Zealand, where financial education is a government priority.

We’re not teaching kids about money at home either. Teens’ top source of money is gifts from friends and relatives. The share that holds a summer job is down 50% the last 20 years even though the value of summer work goes well beyond learning how to save and budget.

These data points suggest a downward spiral of sorts: we don’t save enough even though we are more responsible than ever for our individual financial well being, and we aren’t doing enough to break the trend among younger generations that will have even less of a safety net. Much of the issue would disappear if individuals simply bumped up their savings rate to at least 10% (better yet, 15%) and young people started early and let compound growth over an additional 10 or 15 years do the heavy lifting for them. Forget anything the critics say: financial education can change that. Until then, though, only households in the top 40% of net worth (at least $164,000) can expect their kids to have as much wealth as the parents. These numbers don’t lie.

Do you need help getting your retirement planning off the ground? Email makeover@moneymail.com for a chance at a free makeover from a financial pro and a story in Money magazine.

MONEY retirement income

Boomers Are Hoarding Cash in Their 401(k)s—Here’s a Better Strategy

Paul Blow

Yes, you need a cash reserve in retirement, but you can go overboard in the name of safety. Here's how to strike the right balance.

As you close in on retirement, it’s crucial to minimize the risk of big losses in your portfolio. Given how expensive traditional safe havens, such as blue chips and high-quality bonds, have become, that’s tricky to do today. So for many pre-retirees, the go-to solution is more cash.

How much cash is enough? Many savers seem to believe that today’s high market valuations call for a huge stash—the average investor has 36% in cash, up from 26% in 2012, according to a recent study by State Street. The percentage is even higher for Baby Boomers (41%), who are approaching retirement—or already there.

That may be too much of a good thing. Granted, as you start to withdraw money from your retirement savings, having cash on hand is essential. But if you’re counting on your portfolio to support you over two or more decades, it will need to grow. Stashing nearly half in a zero-returning investment won’t get you to your goals.

To strike the right balance between safety and growth, focus on your actual retirement needs, not market conditions. Here’s how.

Safeguard your income. If you have a pension or annuity that, along with Social Security, covers your essential expenses, you probably don’t need a large cash stake. What you need to protect is money you’re counting on for income. Calculate your annual withdrawals and aim to keep two to three years’ worth split between cash and short-term bonds, says Marc Freedman, a financial planner in Peabody, Mass.  That lets you ride out market downturns without having to sell stocks, giving your investments time to recover.

This strategy is especially crucial early on. As a study by T. Rowe Price found, those who retired between 2000 and 2010—a decade that saw two bear markets—would have had to reduce their withdrawals by 25% for three years after each drop to maintain their odds of retirement success.

Budget for unknowns. You may be able to anticipate some extra costs, such as replacing an aging car. Other bills may be totally unexpected—say, your adult child moves back in. “People tend to forget to build in a reserve for unplanned costs,” says Henry Hebeler, head of AnalyzeNow.com, a retirement-planning website.

In addition to a two- to three-year spending account, keep a rainy-day fund with three to six months of cash. Or prepare to cut your budget by 10% if you have to.

Shift gradually. “For pre-retirees, the question is not just how much in cash, but how to get there,” says Minneapolis financial planner Jonathan Guyton. Don’t suddenly sell stocks in year one of retirement. Instead, five to 10 years out, invest new savings in cash and other fixed-income assets to build your reserves, Guyton says. Then keep a healthy allocation in stocks—that’s your best shot at earning the returns you’ll need, and you can replenish your cash account from those gains.

MONEY 401(k)s

Why Your 401(k) May Only Return 4%

Faucet dripping coins
peepo—Getty Images

The biggest dilemma in retirement investing may be how hard it will be to grow our savings in the next decade.

There have been a lot of predictions from professionals lately about what kind of returns we can expect on our investments, and it doesn’t look good. In June PIMCO bond guru Bill Gross announced at the Morningstar conference (and subsequently to almost every media outlet in existence) that a close-to-zero interest rate was the “new neutral.” Gross envisions a market where bonds return just 3% to 4% a year on average, while stocks return a modest 4% to 5%.

Gross’s forecast echoes that of a number of other investment experts, including Ray Dalio, the head of Bridgewater Associates, the world’s largest hedge fund, who called this post-Recession era we are in “the boring years,” during which investors are likely to earn returns of just 3% for bonds and 4% for equities.

These low-return predictions are based, in part, on diminished expectations for the U.S. economy, with the IMF recently warning that our GDP growth may get stuck at 2% for the long term unless Washington adopts significant reforms.

A 4% return would be a huge decline from the historical performance of the U.S. stock market, which has earned an average annual 10% over the last 40 years. Many financial planners still use 8% to 10% as the expected return for stocks in 401(k)s and other investment portfolios. All of which presents a real predicament for those of us in the middle of our careers who have been assuming strong growth will carry us over the finish line.

You see, the real benefit of starting to invest early, the reason people in their 20s are exhorted to open retirement accounts, has always been the power of compounding in the last 10 or so years of a 40 year horizon—the hockey stick uptick on a line graph. But in order to experience that exhilarating growth curve, you need to earn an average annual return in the high single digits, not the low single digits. Compounding simply doesn’t have as much power if you start off earning 10% for 20 years and then earn only 4% for the second 20 years.

If these predictions come true—and I hope that they won’t—it will be much more difficult to make money off of money in the future. This will impact just about everybody age 40 or older: current retirees and people living off fixed incomes, those hoping to retire in five to ten years, and those in mid-career who will need to rethink their strategy moving forward.

The only real solution, as far as I can tell, is to save more and spend less. You can try to earn more, but another strange feature of this recovery-that-doesn’t-feel-like-a-recovery is that while unemployment has dropped, wages have remained stagnant. Besides, depending on your tax bracket, you would have to earn a lot more to get to the same amount after taxes that you could put aside by saving.

So while the investment pundits are making their predictions and coining their phrases, allow me to offer my own: we may now be entering the era of the New Frugal. After three decades of a declining personal savings rate, from 10% in the 1970s to 1% in the 2000s, the financial crisis of 2008 brought savings back up above 5% where it continues to hover. My prediction is that if stock market returns become stagnant, we might continue to see a reduction in consumption and an increase in savings.

What this all means for the economy as a whole I will leave to the experts to ponder. All I know is that if I can no longer expect a 10% average annual return on my retirement fund, I’m going to be a heck of a lot more conservative about how much I spend.

Konigsberg is the author of The Truth About Grief, a contributor to the anthology Money Changes Everything, and a director at Arden Asset Management. The views expressed are solely her own.

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