(This article is adapted from the new book, The 5 Years Before You Retire by Emily Guy Birken.)
When I was a child, I struggled with perfectionist tendencies and would get very angry with myself whenever I made a mistake. My mother used to reassure me by saying, “Everyone makes mistakes. That’s why they put erasers on pencils.”
The unfortunate truth, though, is that some mistakes are much costlier than others, and we don’t always get a do-over if we’ve screwed up. This can definitely be the case with making financial mistakes in planning your retirement during the five years before you retire.
With limited time to recover from mistakes and the high consequences you face if you make one, it’s clearly better to avoid retirement planning mistakes than to try to recover from them. Having the necessary knowledge to avoid these five pitfalls can keep you from jeopardizing the retirement you want and deserve.
Pitfall No. 1: Relying on Factors Outside Your Control
While you might roll your eyes at someone who talks dreamily of the day his ship will come in and what he’ll do with all that imaginary wealth, near-retirees often make the same mistake. They’ll make their plans for retirement contingent on things that they cannot control.
Finance guru Dave Ramsey has suggested that the average investor can count on a 12 percent return. I have a great deal of respect for Ramsey’s advice on becoming debt-free, but his suggestion that anyone can expect 12 percent returns is simply irresponsible.
While stock market returns are historically closer to 10 percent and last year was terrific for stocks, investors need to take to heart the fact that past returns are no guarantee of future results.
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Counting on a particular return to have the retirement you dream of means you’ve given up control over your own future. You cannot control the market — although you have complete control over how much you save and how much you spend.
Similarly, expecting to inherit money from a wealthy relative is foolhardy as a retirement scheme. Not only do wealthy relatives have the disconcerting habit of living what seems like forever, they also sometimes fall for beautiful young things or idealistic causes in their final years — meaning they change their wills.
Markets are volatile, promises can be reneged and nothing is guaranteed.
Pitfall No. 2: Overreacting to Market Volatility
When we see our investments take a huge hit, it’s difficult to stop our inner Chicken Littles from freaking out over the sky falling and yanking all our cash out of the stock market. But jumping at a temporary downturn a few years before retirement is the way both madness and lost revenue lie.
Getting out of the game means that you have made a temporary loss a permanent one.
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According to Joni Clark, Chief Investment Officer for asset management firm Loring Ward, “everyone who converted to cash in 2008 —especially after the market dropped — locked in those losses, which meant they also missed the market surges that took place in 2009.”
Our tendency to overreact to losses is known as loss aversion. This weird quirk of our brains makes us work harder to avoid a loss than to earn a gain.
That’s why I avoid looking at my investments more often than quarterly. Paying daily, weekly, or monthly attention to your portfolio can tempt you to get out of investments that are only taking a temporary dip. By limiting your exposure to the information, you can make more rational decisions.
Pitfall No. 3: Investment Inactivity
After reading about the overreacting pitfall, you may be thinking that the best thing to do managing your investments as retirement approaches is absolutely nothing.
But a set-it-and-forget-it mindset means you could miss out on growth opportunities for your investments.
To avoid that problem, you’ll want to keep your assets diversified and rebalance your portfolio if, say, the markets have made the portion of your stock or bond holdings larger or smaller than you intended. If you have a financial adviser, he or she can help you rebalance appropriately.
Says Clark: “Define your plan for diversifying and then rebalance regularly — whether once a quarter, once every six months, or once a year. Sell the assets with the most growth to bring your portfolio back into alignment with your plan.”
Pitfall No. 4: Not Setting Aside Enough Income
One of the distressing aspects of the 2008 market downturn was watching those who had planned to retire that year lose a huge portion of their nest egg just as they were ending their career.
Rather than simply accept that you may have to sell some investments at a terrible time, because the market is down in the year you retire, you can protect yourself. Have the equivalent of one- to three-years’ worth of living expenses set aside in conservative, short-term assets, such as short-term bond funds or money market funds.
Then, if you do retire at the bottom of a downturn, you’ll have a cushion that will give your investments time to recover and won’t need to sell them at a time that will cripple your nest egg for the rest of your retirement.
Pitfall No. 5: Taking a Loan from Your 401(k)
This is an enormous no-no at any time in your career, but it’s a particularly disastrous mistake if you’re within five years of your retirement.
Money removed from your 401(k) is cash that cannot grow, tax-deferred. And most 401(k)s won’t let you continue contributing to the plan while you have a loan. What’s more, if you borrow from your 401(k), and lose or leave your job, you’ll need to repay the loan immediately.
If you really need to borrow money, look into a home-equity loan rather than taking money from your own future.