Fred’s Thinking

Good Morning Relaxing Retirement Subscriber,

The father of a mentor of mine had a great saying, “You can learn from everyone, even if it’s an example of what NOT to do!”

I had such an interesting conversation a few weeks back that I just have to pass it on to you. It’s that important.

A really good guy, who worked with one of our Relaxing Retirement members (I’m going to refer to him as “Fred” to protect his privacy), visited our office for the first time for his Retirement Strategy Assessment. Fred is planning on retiring in the next six months, and he wants to make a smooth transition.

During the course of our lengthy discussion, I learned that Fred’s retirement income will come from social security (for him and his wife), and a small amount of (net) rental income from a two-family home that he owns with his brother.

To make up the difference and fill the gap, the remainder will predominantly come from his 401(k) plan at work that he’s been contributing to for years, including maxing out contributions over the last eight.

As we walked through Fred’s numbers to determine how much he would need to draw from his Retirement Bucket of investments each year to supplement social security and their rental income, I asked Fred an important question: “do you know the rate of return you need to earn to generate that supplemental income, and keep pace with inflation so your money doesn’t run out?” (By the way, if you don’t have the answer to this question, STOP whatever you’re doing and find out)

His response was, “I want 10%!”

Having Fred’s numbers that he provided sketched out on The Retirement Bucket worksheet right in front of us, I asked him how he arrived at that number.

Fred said, “I’ve been tracking my plan at work and that’s what it’s been doing.”

Key Lesson #1

There are two great lessons here. First, I asked Fred the rate of return he needed to earn, not the rate he wanted to earn.

Over the last 28 years, when asked the same question, I’ve only had 3 individuals tell me the rate of return they needed to earn, and two of them were wrong in their estimate because of incorrect assumptions. Everyone else did what Fred did; they told me the rate of return they wanted to earn.

The challenge with this is that without knowing the rate of return you need to earn at this critical stage in life, you are throwing darts at a board and constantly chasing the next “hot” thing. This is a recipe for disaster and massive amounts of frustration.

If you don’t know the investment rate of return you need to earn, how can you evaluate if the investments you currently own, or if the investment you’re considering, have the potential to do the job? You have no measuring stick!

Key Lesson #2

When I asked Fred where he came up with a 10% rate of return as his goal, he said that he’s been tracking the fund that he owns in his 401(k) plan at work and that’s what it’s “doing”.

It’s a great fund,” Fred said.

I then asked him how long he had been tracking the fund.

His response, “all year long!”

Now, before going any further (there’s more), let’s talk about Fred’s ‘thinking’.

First, Fred has fallen prey to a colossal mistake that the majority of investors fall prey to; he believes in his heart that because his fund in his 401(k) plan at work has “done” 10%, that it is “doing” 10%.

The problem with that thinking is the “doing” assumption.

In the world of investments, there is no such thing as “doing”. The only thing we know about any investment is how well it has “done”.

How well it will do in the future, which is what we are now concerned with because it has to support Fred’s lifestyle for the next 30 years, is all based on someone’s OPINION. There’s no guarantee.

In Fred’s defense, whenever an investment has just gone up, most people tend to believe that it will continue to go up. It just “feels” that way.

This is why the greatest inflows into equity mutual funds in this country occur right after market prices reach an all-time high as the DOW just did after the presidential election.

The opposite is also true. When prices drop swiftly, most panic and buy into “the sky is permanently falling” mindset, hence the reason why the largest level of outflows from equity mutual funds occur when prices have just fallen rapidly. A great recent example of this was after The Brexit Vote.

Key Lesson #3

Fred stated his investment return goals in “nominal” terms. When you determine your investment goals and later evaluate your progress, you have to do so using real return percentages. Here’s the difference:

If you determined that you earned an 8% nominal rate of return in a given year, you might feel great about that. However, if you did so in an environment like we had back in 1980 when inflation was in double digits, you would conclude that your “real” return, as measured against inflation, was negative.

On the other hand, if you earned 4% in a given year, you might be disappointed with that nominal return. However, if inflation in the same year was between zero and one percent (as it is clocking in at right now in the United States as indicated by the paltry Cost of Living Adjustment to your Social Security income), then 4% is likely a very good return.

The key is to set goals and measure progress in real terms, i.e. relative to purchasing power after the impact of inflation.

The Kicker

The kicker in all of this was Fred’s response upon revealing all of this to him. Fred’s question was, “well, what rate of return can you get me? I met with Fidelity last week, and they said 8%. That’s lousy!”

What Fred was looking for here was a magic pill.

What’s sad is that when someone gives Fred a truly convincing ‘sales pitch’ promising him a big rate of return, he will likely to fall for it!

And, this is a highly educated man; a white collar professional for over 37 years.

Fred didn’t lack intelligence. Like the overwhelming majority of Americans, he had never been taught the correct questions to ask.

What Can We Learn From This?

For starters, although I’m sure you’re shaking your head at Fred right now, I don’t want to downplay the seriousness of the situation. Fred is not 40 years old. He’s 65. He doesn’t have another 25 years left to work and earn income to make up for a “loss” suffered because of bad thinking.

His Retirement Bucket now has to support him for the rest of his life. If it runs dry, it’s no laughing matter. He’s going to be in BIG trouble. And, all the trouble he went to in order to diligently save over all these years will have all been for naught!

What I’m hoping that you will learn from me telling Fred’s story is that when you’ve reached the point in your life where the money you’ve accumulated now has to support you, you have to think differently. The downside risk is too great if you don’t.

Before you can even begin to think about allocating investments at this stage in your life, you have to determine the rate of return you need to earn to generate the lifestyle sustaining income you need so you don’t run out of money.

This is very different from the rate you ‘want’ to earn.

Once you know that rate, you can then go about designing an investment allocation that has the best opportunity to generate that return.

Chasing after investments or asset classes that have just done well, and assuming that they will continue that upward pace forever, is what amateurs do. That’s why so many people are so unsuccessful at investing, especially during their retirement years.

Don’t fall into that trap. It’s too dangerous in its simplicity.

Committed to Your Relaxing Retirement,

Jack Phelps

The Retirement Coach
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(The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)