U.S. Markets closed

81% of Workers Are Making a Huge Retirement Savings Mistake -- Are You One of Them?

Wendy Connick, The Motley Fool

Saving for retirement is definitely a high financial priority, yet making those contributions is only the first step. What you do with your retirement savings will determine whether or not you hit your financial goals. And according to the Annual Transamerica Retirement Survey, 81% of workers are making a serious mistake about how they choose to invest their retirement savings.

How workers are investing their retirement savings

The Transamerica survey found that 42% of retirement savers have a "relatively equal mix" of stocks and bonds in their retirement investment portfolio. Another 18% have the bulk of their retirement savings in bonds. And most worrisome of all, 21% didn't know how their retirement savings were invested.

Worried couple looking at document

Image source: Getty Images.

Too many bonds spoil the retirement portfolio

While stocks and bonds are indeed the retirement investments of choice, having too high a percentage of your retirement portfolio in bonds is a serious mistake. Bonds have a much lower average long-term return than stocks do, meaning you're far less likely to get a high enough balance in your accounts if you rely too heavily on them. Yet that's just what the majority of retirement savers are doing.

A simple way to determine how to allocate your retirement money is to subtract your age from 110 and put that percentage of your portfolio in stocks, with the remainder in bonds. For example, a 40-year-old would have 70% of his or her retirement savings in stocks and the remaining 30% in bonds. Using this formula, you shouldn't reach a 50/50 split between stocks and bonds until you hit age 60, yet that's how almost half of retirement savers are allocating their funds.

How asset allocation could change your returns

As an example, let's look at Bob and Sue, two imaginary 40-year-old retirement savers. Both Bob and Sue plan to retire at age 65, so they've got 25 more years to go. Each has $100,000 saved in his 401(k), but while Bob has chosen to allocate his money in the recommended proportion of 70% stocks and 30% bonds, Sue has chosen a 50% stocks/50% bonds allocation. For purposes of this example, we'll use a return of 10% per year for stocks and 5.5% per year from bonds (these are the average annual long-term returns for those two types of investments).

Bob has $70,000 worth of his portfolio in stocks, so at a 10% annual return those investments would grow to $758,429 after 25 years. The $30,000 worth of bonds would grow to $114,402 over the same time span, assuming a 5.5% annual return. That means that by the time he's ready to retire, Bob's $100,000 will have turned into $872,831.

Sue has $50,000 worth of her portfolio in stocks. After 25 years of 10% annual returns, that money would grow to $541,735. The $50,000 of bonds, at a 5.5% annual return, would grow to $190,670 over the same time period. Thus, Sue's $100,000 will turn into $732,405 by the time she reaches age 65. In short, Sue's choice of a 50/50 allocation between stocks and bonds will cost her $140,426 based on average long-term returns.

While this example is simplified and doesn't take additional contributions or annual rebalancing into account (see the previous section on how to manage this), you can see how having too high a percentage of bonds versus stocks can hold back your investments from their potential growth. It's especially important to have a high percentage of stocks when you're young, since the effects of low (or high) returns will be magnified over decades.

But aren't stocks risky?

Stocks tend to be far more volatile than bonds (meaning that their value is likely to veer up and down unpredictably). And that's why it's recommended that workers reduce the percentage of their total portfolio that they have in stocks as they get closer to retirement. A 30-year-old with a large percentage of stocks in a portfolio would be little affected by even a severe a market crash, since the investments have more than 30 years to recover their value by the time that investor will actually need to start using them. A 60-year-old, on the other hand, won't have a lot of recovery time for a portfolio, so he or she should have significantly more of the portfolio money in bonds than a younger worker.

Given how hard it is to save enough money for retirement, it's essential that the money you do save produces the highest possible returns. The more returns you can squeeze out of your savings, the less you'll need to save in order to hit your goals. And that means keeping as much of your portfolio as you safely can in stocks.

More From The Motley Fool

The Motley Fool has a disclosure policy.