According to a cover story in the May 16, 2008 edition of USA Today, lower stock returns and falling home prices may make it more difficult to retire on a 401(k) or similar retirement account and the equity in your home.
Since the beginning of the year, Patty Stewart, a 49-year old resident of Redland, California , has seen the value of her 401(k) fall about 4 percent. In addition to minimized returns, Stewart was forced to reduce her retirement contributions to offset the rising cost of living expenses. Home prices in Stewart’s neighborhood are off about 25 percent over a two-year period, which means that it is not likely that she can rely on tapping her home equity to supplement retirement income. According to Stewart’s calculations, she will need $1.3 million to $1.5 million for retirement, which she says “doesn’t seem like it’s something that will ever happen.”
For years, investors have been led to expect average annual returns of 8 to 10 percent on stocks and home appreciation of 10 percent annually. These assumptions were based on two decades of outsize returns that were inflated by low interest rates fueling bubbles in the values of stocks and real estate. Today, financial analysts predict a prolonged period of below-average returns on both stocks and home equity. Since Americans are not likely to have as much money for retirement as originally thought, many will have to save more, expect less and work longer than planned.
Some economists believe that the economy in the immediate future will resemble that of the 1970’s rather than the 1980’s and 1990’s. For investors, the 1970’s were quite bleak. From 1966 through 1982, the performance of the Dow Jones Industrial Average, not counting dividends, was essentially flat.
Greg Womack of Womack Investment Advisers encourages investors to be conservative in their financial projections. “Any time you look forward and do forecasting, it’s better to do it on a more conservative basis.” Factoring in an above-average rate of inflation and a below-average rate of return on your investments is essential. “If things turn out better, you’re ahead of the game,” Womack advised.
In addition to lowering expectations for high stock returns, investors should also consider the following:
- Inflation.
Higher inflation tends to damage stocks partly because rising consumer prices trigger higher interest rates. Higher rates, in turn, can weaken corporations and the overall economy. Inflation also hurts savers by forcing them either to put aside more money or try to earn more on their investments.
Since retirees spend a disproportionate share of their income on items that tend to rise faster than overall inflation, such as food, energy, and health care, the outlook is especially bleak. While most retirement calculators assume an annual inflation rate of about 3 percent, that figure reflects two decades of below-average inflation. Given the rising demand for food, energy and health care around the world, savers, investors and retirees should plan on higher inflation in the years to come.
- Taxes.
Wall Street analysts argue that the widening federal budget deficit, coupled with an increased demand for Social Security and Medicare programs, will force the next administration to raise taxes. If higher taxes lead to lower stock prices, investors will earn less. Meanwhile, retirees will pay higher taxes on withdrawals, reducing their after-tax income.
- Home Equity.
During the height of the recent housing boom, Americans saw their homes appreciate much faster than the mutual funds in their retirement accounts. This led many to believe they could supplement retirement savings by selling their homes, downsizing and pocketing the difference. Others believed that a reverse mortgage would be an extra source of income. (A reverse mortgage is a loan against home equity that is repaid when the borrower moves, sells the home or dies.)
A study conducted by the National Council on Aging in 2005 estimated that reverse mortgages could help more than 13 million Americans pay for long-term care. According to Moody’s Economy.com, nearly 9 million homeowners owe more on their mortgages than their homes are worth. Since the housing boom peaked in 2006, home prices have fallen more than 15 percent nationwide, thus wiping out billions of dollars in home equity.
- Savings.
If homes are taken out of asset calculations, Americans will need to rely even more on retirement savings and other investments to pay for retirement. As inflation and a sluggish economy weigh in on their investment returns, workers will find it harder to save more.
Financial planners believe that workers who start saving early or more will still be able to meet their retirement goals. A recommended course of action is to pay off loans and other debts as fast as possible, which will free up cash to invest in retirement savings.