No Rule of Thumb When It Comes to Retirement Portfolios

This week, Gail explains why there is no "rule of thumb" when it comes to the percentage of stocks in your retirement savings and -- again! -- advises against taking money out of your retirement plan to invest in a business venture.

Dear Gail,

I am 64 years old. My wife (age 60) and I both work full-time and have 401(k) plans. Right now we both have about 75% of our 401(k) plans in equities.

I have read that you should subtract your age from 110 to come up with the percentage of your portfolio that should be invested in stocks. But we've attended seven financial workshops in the past two years and those advisors have pooh-poohed the rule, saying that retired people need income a lot more and for a longer time.

What do you think?

Mike

Dear Mike;

The problem with a "rule of thumb" is that it is rarely appropriate. I think that guideline of "110 minus your age equals the percentage you should have in stocks" is so broad it is useless. It fails to take into account your individual experience, needs, temperament, health, time horizon, etc.

First of all, it is a mistake to look at your 401(k) plan in isolation. You need to lay out ALL of your investments, including CDs, money market funds, bank accounts, plus stocks and bonds you own outside your company plan. While you're at it, throw your IRAs and annuities in, too. That will give you the total picture of how your investable money is allocated.

How much of this total ought to be in stocks is not something I or any other financial advisor can ethically tell you without taking the time to gain a thorough understanding of your complete financial picture. I strongly advise the two of you to stop spending your time going to workshops and find an experienced advisor you feel comfortable working with who can explore this with you and develop a workable plan. At this point in your lives -- right at the cusp of retirement -- you can't afford to take a do-it-yourself approach. Once you retire, you will no longer be able to make up mistakes by earning more income.

Once you decide how much of your total portfolio should be devoted to equities, you need to consider at least five separate sub-headings in order to give you diversification: large-cap U.S. growth stocks, large-cap U.S. value stocks, small-cap U.S. growth stocks, small-cap U.S. value stocks, and international stocks. You might also want to think about adding mid-cap value and mid-cap growth to the mix. How much -- if any -- of your total stock allocation goes into each sub-category is another decision.

In general, I agree with the financial advisors you have heard: the average person is going to spend almost the same amount of time in retirement as he/she spent in the workforce. You cannot afford to be overly cautious with your investments. If you put too much money into fixed-income assets, you run the risk of having inflation erode your lifestyle.

Suppose you are both healthy and retire when you are age 65. That means your wife will be 61. You will probably live another 20 years. That's a long time! Since your wife is younger and women typically live 5-7 years longer than a man, she could spend 25-30 years in retirement. Your retirement portfolio needs to reflect a time horizon of two to three decades.

If inflation runs just 3% a year and the income produced by your retirement portfolio doesn't grow at least as fast, the lifestyle you can afford will decline. In fact, in 24 years, a 3% inflation rate will cut the purchasing power of a dollar in half, meaning at that point you will need twice the income just to be able to afford the same standard of living! If either of you becomes ill or inflation increases at a faster rate, then you'll really be in trouble.

One of the biggest mistakes people make is assuming that "fixed income" equates to "secure." Bond prices can fluctuate just like stock prices. (You don't have to look farther than 1994 to verify this.) And locking up too much of your money in CDs can also be devastating. Think about what happend to the folks who thought they were taking the conservative approach back in the early 1980s: instead of diversifying into the stock market, they kept rolling their money over into CDs. By the end of the decade, their income was a fraction of what it had been 10 years before because CD rates had collapsed AND they also totally missed the bull market in stocks.

No matter what your age, you need to diversify your investments. There is no "formula". This is more art than science. It's got to be tailored to your individual needs and circumstances. Do yourselves a favor and team up with a professional.

Best wishes,

Gail

Hi Gail,

I have recently been told that my job has been eliminated. I am receiving a severance pay package worth 1 1/2 weeks pay times the 18 years of service I have accrued. I am planning on rolling this into a sports bar and grill with my brother-in-law. I have a 401(k) plan worth about $136,000. What is the best way to draw $100,000 out to roll into the sports bar with the least amount of penalty involved?

Thank You!

Bradley

Dear Bradley,

First of all, let's separate your issues. The money you will receive as a severence package will be considered income for this year and you will owe taxes on it. In all likelihood, this will place you in a higher tax bracket, which will whittle down your take-away considerably. Before you do anything with this money, I recommend setting aside an amount equal to the taxes you'll owe on April 15.

Taking money out of your retirement plan to invest in the sports bar is also going to result in a big tax bill. First of all, every dollar you withdraw from your 401(k) plan will be subject to ordinary income tax. In addition, if you are under age 55, you will also pay a 10% penalty.

Let's do some rough math. If you withdraw $100,000 from your company retirement plan, your total income this year (add up your regular salary until your lay-off date, plus your severance package, plus your 401(k) withdrawal) will probably put you into at least the 30% tax bracket, reducing your usable cash to $70,000. If you're under age 55, subtract another $10,000 for the 10% penalty. Now instead of $100,000, you've only got $60,000 to work with. You've lost 40% of your 401(k) withdrawal!

I understand your desire to come up with the money for this venture. But if you are under age 55, this is really going to be costly, both in the short run in terms of taxes and penalties, and in the long run because you're depleting a major source of retirement income. I encourage you to consider raiding your retirement money only as a last resort. Use your severance, take out a loan (maybe your brother-in-law can extend you credit?), or tap other forms of savings.

Let me put it this way: if you left the $100,000 in your 401(k) or rolled it over into an IRA where it could continue to grow tax-deferred, and it earned just 8% a year, in 18 years it would be worth $400,000!

However, you cannot avoid either taxes or the 10% penalty by rolling your 401(k) balance into an IRA and then withdrawing the money from the IRA. In fact, this could make things worse, since you don't lose the penalty on IRA withdrawals until age 59 1/2. There is a provision in the tax code which allows you to take out "substantially equal" amounts of money from your IRA, but you have to continue making withdrawals for a specific period of time. In your case, this won't help because you want all the money up front, not spread out over several years.

I wish I had a happier answer for you. All I can say is, "Ouch!"

Gail

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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.