Time to Get Real
by Penelope Wang

November 9, 2007

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Unless you expect your children to support you in retirement, stop thinking like an all-nurturing parent. When you have kids, it's only natural to believe that college needs are more pressing than your far more distant retirement. A recent survey by the College Savings Foundation found that 53% of parents consider college savings their top priority, ahead of retirement or a house.

Problem is, this kind of thinking can lead you to pass up a big weapon: the power of compounding over time. Save $100 a month from age 25 to 35, then stop and let the money grow. You'll have $182,000 in 30 years. Wait until you turn 45 to start saving and you'll have to put away $315 a month for 20 years to end up with the same amount. Then too, if you come up short when it's time to pay for college, you (and your kids) can get help, from loans to outright grants. You can't apply for a retirement scholarship at age 65.

That doesn't mean you should give up entirely on saving for college or other goals. Just make putting away money for retirement your top priority. As for college, don't assume you have to save enough to pay the full price tag—for most families, a reasonable goal is to save for a third of the costs and make up the rest through financial aid, loans and your income when classes start and the bills roll in.

Treating your house as the ultimate retirement insurance is an easy trap to fall into. Even with the housing market in the doldrums, the five-year real estate bull market has likely left you feeling house-rich. According to a 2004 study by the National Economic Bureau, upper-income boomers ages 51 to 56 have a third of their net worth invested in their principal residence. As recently as May, a survey of affluent boomers by financial adviser Bell Investments Advisors found that nearly 70% were relying on their homes as a retirement asset. Question is, will the strategy work? The answer is, not that well.

Why? Because it's hard to eat out on your home equity. You have to live somewhere. To turn your equity into cash, you can sell and then rent, move to a cheaper area or downsize. Most retirees prefer to stay put. Yes, you can do what a small but growing number of retirees are doing: Get a reverse mortgage, which is a loan against the value of your house that you don't have to pay back. (When you die or move out, the loan is paid off by the sale of the house, which means you may not be able to pass the home on to your children.) But these loans give you much less than the value of your house. For homeowners ages 62 to 69, lenders will typically let you borrow just 49% of your home equity, says Wharton finance professor Nicholas Souleles.

The best way to look at your house is as a place to live, not a retirement account. So in the years leading up to retirement, don't overinvest in it with the idea that you can get that money out later. Keep your mortgage and other housing expenses to no more than 28% of your income, and don't prepay your mortgage instead of saving for retirement.

It's comforting to look at historical returns. Despite the occasional setback, the market continues to rise over the long run. In any 10-year period since 1926, you'd have made money in stocks 97% of the time; over 20 years you'd be ahead 100% of the time. As long as you're patient and keep investing, you'll do well, right?

Not necessarily. When you're far from retirement, you can tough out even devastating bear markets, buying low while you do. Once you near your quit date, the rules change. Say you were within a few years of retirement in January 2000, on the eve of the March 2000 to October 2002 meltdown, when stocks plunged 44%. If you were solely in stocks, it would have taken you 4½ years just to break even. But if you'd had 60% of your portfolio in stocks, 30% in bonds and 10% in cash, you'd have had far milder losses of 21%.

Once you start cashing out, a bear market of that magnitude can seriously jeopardize your standard of living. If you were a retiree with that same all-stock portfolio in the 2000-02 bear market, those losses would mean you'd have only a 43% chance of seeing your money last until age 85 vs. 80% if you had a more conservative allocation.

Some beliefs are so deeply held that no amount of evidence can dispel them. Six years after the fall of Enron, many workers have wised up to the risk of owning shares in their employer. Company stock makes up 11% of assets in 401(k) plans that offer it, says EBRI, down from 19% in 1999. But that drop is partly due to younger workers staying out of employer shares—42% of new hires invest in company stock in plans that have it vs. 61% in 1999.

Keeping more than 10% of your money in your company stock poses a double risk: If something goes wrong with your company, both your job and your retirement portfolio are on the line. You may know your company, and it may be a great business, but you can't be sure the stock will outperform. In fact, studies show that over time any company's stock performance will likely be average. So why take above-average risk? Fortunately, new 401(k) rules governing company stock allow you to diversify out of employer shares after three years. Do it.

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