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Three Pitfalls to Avoid in Retirement

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. In investing, the mistakes you don't make can be just as crucial to your success as the things you got right.

In that vein, Morningstar's Christine Benz, director of personal finance, is here to tell us today about three investing pitfalls to avoid in retirement.

Christine, thanks for joining me.

Christine Benz: Jason, nice to be here.

Stipp: So, the first one has to do more about timing than about a specific product. Can you tell us a little bit about the first thing that you should really think about and try to avoid in retirement?

Benz: Well, one thing a lot of retirees are talking about right now is annuities. They want that guaranteed source of income during retirement, and certainly there is a lot of academic research that points to annuities being a good long-term component of portfolios. These are single-premium immediate annuities. So these are the ones where you give your money over to the insurer, and they send it back to you as a stream of payments over the rest of your life.

The key risk of buying annuities right now, though, is that with interest rates as low as they are, the payout that you earn for that pool of money that you would send to the insurer may not be that much. So I think there is a great risk in casting a lot of your portfolio into an annuity right now given the currently low yields.

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Stipp: Are there are other things to consider, obviously the rates are low right now, but the rates might go up, there might be inflation. Is that potentially something you should also think about if you're putting money into a product that's going to be paying you a fixed amount back?

Benz: Absolutely. So there are some annuities you can buy that do include inflation protection, which is worth considering, and then I've also been hearing about a new type of product that actually steps up your payout as interest rates increase.

So that sounds appealing. The key downside to strapping on either of these protections is that you will pay more; so your initial payout will be reduced.

So, one thing that you can do to mitigate that time-specific risk of putting a lot of money into an annuity right now, is actually to ladder your annuity contributions over a period of years, and that also has a salutary effect. In doing so, you can split your contributions among a variety of insurers to limit that insurer-specific risk.

Stipp: So one way is sort of to hedge against the current low rate environment.

The low rates also are presenting another problem for income investors. So I think that maybe a few generations ago, retirees would actually just want to just spend the income on their portfolios and not touch their principal. But today, with rates so low, that really isn't much of an option for a lot of folks, is it?

Benz: No. That's another key pitfall, Jason, I would say is, is focusing on income at the expense of total return. So a lot of retirees I talk to are very much hung up on this idea of getting that livable current income.

So they want their portfolio to generate 7%, 8%, 9% because that's what they need to live on. The fact is you need to venture into some really risky securities these days to generate that kind of livable yield  that's not going to [otherwise] happen.

My thought is maybe you focus on income with one portion of your portfolio, but manage the whole of the portfolio for total return, so you've got your eye on not eroding your capital, and if you need to spend down that capital or that principal, you do so on an as-needed basis.

Stipp: Last thing to think about as well is how much money you're taking out of your portfolio. So, obviously if you're just looking at income that might be a low amount right now, but factoring in the rate that you can take out is obviously important to those assets to last throughout your retirement. How are ways to make sure that you're getting that right and you're not making a mistake there?

Benz: I think, if you were to talk to planners and advisers, if they were to say what is the big mistake I see retirees make, it would be this one--where you've got a lot of new retirees taking withdrawal rates that simply aren't sustainable over a person's life expectancy. So you often hear about this 4% withdrawal rate being the safe withdrawal rate. So it's very unlikely that you would run out of money if you are taking 4% a year.

The key conundrum though is that even if you have a $1 million that's still $40,000 a year. It's maybe not a livable income for someone, certainly a person who has amassed $1 million portfolio, may be he's used to spending more. So anytime you venture beyond that 4% rate, I would say really think about: A, how your portfolio is constructed and B, whether that is a sustainable withdrawal rate. You may want to check with an adviser on that, too.

Stipp: So if I did want to try to stick at 4% but it's not quite as much as I would want, I mean what steps could I try to take to grow my portfolio enough where that 4% might be a sustainable amount? I mean is there any way that I can restructure without becoming too risky?

Benz: Well, you want to balance, and of course, it depends on the retiree, but asset allocation and crafting that appropriate asset allocation in retirement is absolutely key. And I think the fact remains that with longevity rates as long as they are these days, even retirees do need stocks and need some appreciation potential in their portfolio. So you do want to have a mix of stocks and fixed income assets.

Stipp: Well, Christine, some great ideas to know. Thanks so much for joining me.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.