Prior to the stock market taking a major hit in 2008, I would run into the same problem when working with clients and prospective clients who are preparing for retirement. This was a problem that I had seen infiltrating society at all levels and something, I feared, would negatively impact our way of life. What was that problem?
The American people who lost large portions of their retirement accounts cannot be blamed for the bad advice that advisors have been trained to give for many years. If you have a retirement account, perhaps you’ve heard these words before:
Your Still Young
“You’re young, so you should have your money in riskier investments.”
This advice is based on the conventional wisdom that younger workers can absorb risk since, over time, a well-diversified portfolio may grow larger than if money is simply placed in safe investment vehicles and allowed to grow at a relatively low-interest rate over a long period of time. So you likely listened to your advisor, after all, he or she probably has a bunch of letters after their name and a company you heard of on their business card, how could they steer you wrong? So after you lost that chunk of your money, you likely heard them reassure you with these words:
Paper Losses Are Still Losses
“Don’t worry, it’s just a loss on paper.”
This bit of advice comes from the realistic notion that you can’t lose something you never really had. So, if you invest $10,000 in the stock market, then earn an additional $5,000 the following month but then the very next month lost $3,000, we would say your loss only exists on paper. After all, you started out with $10,000 and now have $12,000. The $3,000 you lost was money that wasn’t available to you, and as such, only existed on paper.
But your loss sure does feel real now doesn’t it? Financial Advisors today are still spewing the “paper loss” excuse even though the circumstances are completely different. For example, this year my wife contributed $5,000 to her retirement account. Within 5 months of that deposit, all of it was gone. Every last penny of that $5,000 was gone, plus a little extra.
“No problem.” said her plan administrator. “It’s only a loss on paper. Besides, you’re young enough, you can absorb the risk.”
The conventional wisdom is not always the best way to treat your retirement money, especially in a rather unconventional world. Here are some things you need to know about investment advisors. All investment advisors start out at the same place, as insurance agents. Like their humbler beginnings, financial advisors and financial planners are compensated based upon commission and consulting fees. No matter what your advisors business card says, they are not working for you.
That is not to say that all planners are evil incarnate. I always preferred to approach clients with a needs-based approach. The need that we all share in common is retirement. We all need money so that one day we can pack up our desks and open up that ice cream shop we always dreamed about. What differs is how we reach that goal. Many advisors will tell you that investing in the risky stuff will yield the best results. Under normal circumstances, this tends to work. By diversifying your investments, you are protecting yourself against loss.
Retirement and “The Rule of 120”
Let’s say you have a retirement account worth $100,000 and you are 30 years old. The wily investment advisor will apply what is called the “rule of 120” (which used to be the rule of “100” mind you). In this method, your age is divided by 120 resulting in the percentage of your investments that should be in safer modules. The ideology is simple. The older you get, the safer your investments should be. A 30-year-old can bounce back much easier than an 80-year-old. For the 30-year-old, this results in 25%. So, 25% of your retirement should be in safer investments.
The idea here is that the remaining 75% will be spread out over an assortment of funds ranging from moderate to high risk. As time goes on, that 75% will fluctuate, but as you grow older, more and more will be placed into more secure funds. The end result, ideally, is that you end the game with more than you started with. Here’s the problem.
The idea that risky investments will eventually balance out is a gamble that isn’t for everyone. If you take $100,000 and place it into the stock market, you may see some pretty wild changes. Let’s say in your first year, you gain 15% leaving you with an end of year balance of $115,000. The next year, however, the next economic crisis strikes and you take a 20% hit. Now you are down to $92,000. If you are fortunate enough to see an 8% improvement the following year, you will be right back where you started with the initial $100,000.
Investment in Indexed Annuities
Conversely, you may consider investment in indexed annuities. Many financial advisors I have spoken to say the same thing:
“I would never put someone who isn’t a skilled investor into an indexed annuity, I’d rather put them into a variable annuity.”
Indexed annuities are tax-sheltered investments that allow you to save for your retirement while investing in the stock market. In exchange for a percentage of the stock market gains, you are protected against stock market losses. So, you may place your investment in a fund where you can gain 80% of all gains, in exchange for 0% losses. Indexed annuities are free from market risk while allowing you to still take advantage of future gains.
There exists only one way that you could lose money in an indexed annuity. These are investments made for retirement, you are not mean to constantly switch your money in and out of it. As such, each one comes with a surrender charge generally ranging from 1 to 12 years. As time goes by, the percentage of your money that you would surrender decreases until, after the final year, you can remove your money without any penalty from the company.
Why would investment advisors never put a person’s money into an indexed annuity? This is because they are paid on commission and would rather have you put your money into riskier investments so they can profit from your constant trading.
With an indexed annuity, because of the surrender charges, after the initial deposit, your advisor doesn’t stand to make a cent on your investment for 1 to 12 years. Whereas putting your money into stocks or mutual funds can yield them a regular, monthly profit, whether you gain or lose.
But don’t worry, it will only be a loss on paper.
And hey, you’re young enough, you can always earn more money.