Long-term Investing: 3 Mistakes to Avoid

With medical advances meaning we are all living longer, would-be centenarians should hold more stocks and seriously research annuity options, among other strategies.

Christine Benz 26.05.2014
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A few years ago I attended the 100th birthday party for a family friend. And she wasn't alone on the dais: Her older sister, a former member of the Women's Army Corps, joined her.

These two are the only 100-year-olds I know, but they're not all that unusual any more. In fact, the number of centenarians in developed countries is increasing at a rate of more than 5% per year. At that pace, the population of individuals aged 100-plus will double every 13 years, according to the United Nations' World Population Ageing Report.

Of course, it's still a fairly small subset of the population that will live that long – scare tactics from insurers and other financial-services providers notwithstanding. Just 5% of 65-year-old females and 3% of 65-year-old males in the US will make it to age 100, according to Social Security actuarial estimates. But a much larger percentage - 29% of 65-year-old males and 39% of 65-year-old females – are expected to live to age 90.

Such longevity is often cheered as an achievement, a tribute to individuals' gene pools, healthy lifestyle choices and advances in healthcare. And rightfully so. But the downside of living well beyond one's average life expectancy is that it can strain – or worse, completely deplete – an individual's financial resources. With more baby boomers entering retirement without pensions – meaning that the State Pension is likely to be their only source of guaranteed lifetime income – longevity gains heighten the risk that more individuals will outlive their investment assets.

The first step in addressing longevity risk is to evaluate just how great the odds are that either you or your spouse will have a much longer-than-average life span. Health considerations, family longevity history, employment choices and income level may all be factors. A Society of Actuaries survey claims 40% of adults underestimate their longevity by five or more years.

If you've assessed these considerations and are concerned about longevity risk – or if you've determined that you'd simply rather be safe than sorry – here are some key mistakes to avoid.

Mistake 1: Holding a Too-Conservative Portfolio 
When investors think about reducing risk in their portfolios, they often set their sights on curtailing short-term volatility – the risk that their portfolios will lose 10% or even 20% in a given year. But a too-conservative portfolio – one that emphasises cash and bonds at the expense of stocks – can actually enhance shortfall risk at the same time as it's keeping a lid on short-term volatility. That's a particularly important point these days, given the fact that current yields tend to be a good predictor of returns from these asset classes. Not only are starting yields meagre in absolute terms – the 10-year Treasury bond is yielding just 2.6% and certificate of deposit yields are barely more than 1% (if you're lucky) – but interest rates have much more room to move up than they do down. That will reduce the opportunity for bond-price appreciation during the next decade. With returns like that, retirees with too-safe portfolios may not even out-earn the inflation rate over time.

That doesn't mean longevity-conscious retirees should jettison these safer investments, as they provide valuable ballast for the risky portions of a portfolio. It does, however, suggest that those concerned about outliving their assets should lean their portfolios more towards equities than would be the typical prescription for people in that same age band. Those who think they're likely to live well beyond their average life expectancies would do well to veer towards more aggressive asset allocations. That means an equity allocation of more than 50%, even for those getting close to and in the early stages of retirement. It also means healthy doses of international stocks. (If you find your portfolio is extremely light on stocks right now relative to where you need to be, plan to build your positions gradually rather than dramatically increasing them all at once, as market valuations aren't what they once were.) 

Mistake 2: Not Adjusting Withdrawal-Rate Assumptions 
The topic of withdrawal rates during retirement is a hot topic, and for good reason: Just as our savings rates are the main determinant of success during the accumulation years (much more than investment selection, in fact), spending rate is one of the central determinants of our retirement plans' viability.

The 4% rule – which indicates that you can withdraw 4% of your total portfolio balance in year 1 of retirement, then annually inflation-adjust that sterling amount to determine each subsequent year's portfolio payout – is a decent starting point in the sustainable withdrawal-rate discussion. But it's important to tweak your withdrawal rate based on your own situation. If you have a sparkling health record and it looks likely that you'll be retired longer than the 30-year withdrawal period that underpins the 4% rule, you're better off starting a bit lower. (The fact that bond returns are apt to be meagre in the coming decades is another argument for veering towards the conservative side on the withdrawal-rate front.) On the plus side, you may be able to live on much less than standard rules of thumb (such as 80% of pre-retirement income) would suggest.

In a similar vein, it's important to not set and forget your retirement-plan variables, such as your spending rate and your asset allocation, because retirement progresses and new information becomes available about your health and potential longevity, market valuations, and so forth.

Mistake 3: Reflexively Dismissing Annuities 
There are a lot of reasons many investors avoid products that promise guaranteed lifetime income, such as annuities. They can be high-cost, it can be difficult to part with a large sum of money in exchange for a guaranteed lifetime income stream, and transparency is often lacking. (I'm often surprised by the number of people I run into who own annuities but don't know what they have.) There's also the matter of current interest rates, which have a depressive effect on the payouts of fixed-type annuities.

Despite their drawbacks, guaranteed lifetime income is a huge attraction on the longevity-protection front, and not all annuities are complicated and costly. Single-premium immediate annuities, while the most beholden to the current interest-rate environment, are the least complicated, most transparent and most cost-effective annuity type. Deferred-income annuities, meanwhile, provide an even more direct hedge against longevity risk by enabling you to start up your income stream at some future date--when you hit age 85, for example. 

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About Author

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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