When it comes to retirement planning, what’s important is not how old you are today, it is how long you have until you stop working.
Are You On Track?
As we’ve mentioned before, it’s expensive to retire. But just how much will it take, and how will you pay for it? At this stage, you might be beginning to feel the fever. It could start with a vague feeling that you need to look into exactly how much you are going to need, or it might manifest itself as a cold chill running down your spine (“Oh-my-God-we-are-SO-unprepared-to-leave work”). All of a sudden, the time in your life when you will be living without a paycheck doesn’t seem quite so distant. True, it is 180 months away, but the mere fact that it can be measured that way means it is not that far over the horizon. Time is catching up with you.
Everybody finds themselves in a different situation when they are 15 years away from retirement. Still others might be in the extremely unenviable situation of trying to beef up their retirement savings while simultaneously having to deal with big expenses such as putting a child (or two!) through college or caring for an aging parent. Literally thousands of scenarios are possible. But no matter what situation you find yourself in, we can help. Let’s start by figuring out exactly where you are.
To figure out how much income you will have coming in, begin by checking out the Social Security Benefit Calculator on the Web (www.ssa.gov/planners/calculators.htm). They have an amazing amount of information to help you understand the program and maximize what you will receive. You will be able to get a very close approximation of all the benefits you and your family are entitled to under many different scenarios.
If you are fortunate enough to have a defined benefit retirement plan at work, ask your employer for an estimate of your benefits, or take your benefit booklet and work through the calculations about what you will receive based on your income and years of service. These are relatively simple calculations that shouldn’t intimidate you. At most you will have to multiply three numbers together and subtract a little for Social Security if the plan has an offset. Your “summary plan description” will give you the formula. Add in any other fixed income you expect to receive in retirement from things such as rent, royalties, military pension, and so on.
Is It Enough?
Will I Have Enough?
After you total those figures, the obvious question is this: Will this be enough to get you through your retirement? At this point, you should have an idea of the lifestyle you want to have after you stop working.
One easy way to figure out whether you are going to have enough money to fund your retirement involves really simple math. In most situations don’t want to withdraw more than 4% of your retirement savings in any given year. If you do, you run the very real risk of outliving your money.
So, to determine whether you will have sufficient funds, multiply the amount of money you think you will need from your portfolio by 25. The answer will tell you whether you have saved enough.
Let’s use an example. Say you think you will require $75,000 a year to fund the way you will want to live in retirement. And we will assume that you will have $20,000 a year coming in from Social Security, and will be receiving another $5,000 annually from something like a pension. That means you’ll need to generate $50,000 a year from your retirement savings.
Assuming you are going to withdraw 4% of your money each year, you would multiple the amount of money you will need—$50,000—by 25. In this case, you will need to have $1.25 million in retirement savings to fund your lifestyle in retirement.
(If you were to use a more aggressive 5% withdrawal rate, and we don’t recommend going above that, you would multiple your expenses by 20 and discover that you would “only” need $1 million in savings.)
The difference between what you know will be coming in and the amount of money you will need in retirement will have to come from the money you have put away. After reading all this, we invariably get the following four questions. Let’s deal with them each.
I was on track, but the market just creamed my investment accounts. What do I do now?
The financial meltdown of 2008 wasn’t pretty. However, before you panic, remember you have lots of time for the market to recover. Your retirement is 15 years away. Meanwhile, while the market is depressed, you can buy lots of shares at ridiculously cheap prices. Later on, when the market is substantially higher—and at some point we firmly believe it will be—you will be glad you did. So at the very least, continuing to fund your retirement accounts at the previous level and count on time and compound interest (more on this in just a minute) helping you out.
I’m behind, but we can’t seem to save much. What should we do?
Many couples are experiencing financial hardships and truly can’t save much. The reasons might vary—there might be kids in school, alimony to pay, and/or aged parents to support—but the pressures are very real. Retirement planning isn’t an option when meeting the day-to-day bills seems to be a struggle.
Still, if you have savings, you can optimize what you have by applying smart tactics, and taking the right amount of risk for your situation. For example, eliminate all consumer debt because it will drown you in fees and interest charges.
For others, saving more is possible. Many day-today expenses are optional. The now clichéd advice about cutting out your daily latte and saving the money you would have spent is right. But consider it a metaphor for all the nonessential things you are spending money on (for example, do you really have to go out to eat so often?)—money that could otherwise be shifted to retirement savings without seriously affecting your quality of life.
However, you might be the kind of person who doesn’t have the discipline to budget and save. The only salvation for people like this is to save first and then live on what’s left over. You may max out your retirement plan by having money automatically taken out of your paycheck. Like this, you’ll never see the money you are saving, so you won’t miss it. It more or less painlessly can go into your retirement account and can automatically be invested in an appropriate asset allocation plan that meets your needs at this stage of life.
Just about all the major financial services firms offer mutual funds that do this—they are usually called “lifecycle,” “targeted,” or “age-based” funds. They all work the same way: The fund invests in stocks, bonds, and cash, and becomes more conservative in its allocation as your retirement date draw near. These funds are an acceptable solution if you simply can’t be bothered to manage your account, but we actually think you can exercise more control over your asset allocation by following our suggested plans.
If you are not fortunate to have a quality 401(k) or 403(b) at work, consider an IRA, or Roth IRA. If you are self-employed, you can have almost any kind of pension or IRA you want.
You might be pleasantly surprised when you see how little an increase in your 401(k) or 403(b) contribution will affect how much you take home. Check out our “Retirement Contribution Effects on Your Paycheck” calculator at www.Save-Retirement.com. If you or your spouse have a good plan at work, stash a little more there.
Time is still on your side, and it would be a wonderful idea to make the decision to increase your savings to take advantage of the magic of compounding. To see how much those dollars will grow, check out our “401(k) Savings Calculator” at www.Save-Retirement.com. As you will see, the power of compounding is the only thing that can save people who haven’t yet started to save for retirement.
Fix Bad Habits
Changing Bad Habits
In our experience, almost everybody wishes that they had saved more and started earlier by the time they finally stop working. However, a funny thing happens on the way to retirement. We place a higher importance on things that we want right now than we do on things for later. That shouldn’t surprise us. We do it all the time in other parts of our life. We want to lose weight, but that ice cream cone is just irresistible. We can diet tomorrow. So, naturally we go for the new iPhone, BMW, or long weekend away, even though we really want to retire in style later. We just seem to be hard wired this way.
It’s hard to change bad habits even if we recognize how harmful they can be—just ask any smoker. That’s why we advocate tricking ourselves into saving through some sort of automatic plan that makes us save first—it removes temptation.
Removing temptation is a good thing. If we send off part of paycheck before we ever see it, we can’t spend the money that has been automatically saved.
Perhaps the best thing about our 401(k) system is that for people who use it, it’s an automatic save-first program. After it’s set up, savings happen automatically every pay period, and the participant lives on what is left over. The participant doesn’t have to make the mental effort and exercise the discipline to decide to save and budget hundreds of times a day. The money is taken out of your paycheck before you ever have the chance to spend it.
If you don’t have a high-quality 401(k) or similar employer-sponsored plan to participate in, set up a payroll deduction plan with a good mutual fund company and have them automatically debit your checking account each month, putting that money in the retirement investment of your choosing. Any automatic savings plan has a much higher chance of actually working than trying to save what’s left over at the end of the month. Temptation being what it is, there will seldom, if ever, be anything left over.
In the end, it’s much less important whether we invest in an IRA, Roth IRA, 401(k), or taxable brokerage account than that we actually invest enough and early enough to meet our goals. The most tax efficient, effective, lowest cost investment plan won’t do you any good unless you actually contribute to it, and only you can make that happen.
We really don’t have much sympathy for the idea that you can’t save. Because the thought is so important, let us repeat something we said before: No matter how much or little you make, somewhere there is a person making only 80% of what you are, and they are living a full and satisfying life. So, you could save 20% and live a full and satisfying life, too.
However, there is a good chance that if you are not saving much or anything today, a 20% goal might not be possible at first. However, many 401(k) plans are helping their participants ease into savings painlessly by adopting an escalating contribution scheme. The employee starts off at some tolerable level of contributions; for instance, 3% of their compensation. But the brilliant part of the plan is that the employee agrees to contribute some portion (for instance, half) of all future raises to his 401(k). So, each time he gets a raise, his contributions increase, and he has more take home pay, too. Before long, the average employee is contributing 14% or so and not missing it. If your employer’s plan doesn’t offer this feature, which is often called “save more tomorrow” or a SMART plan, ask them to do so. If they don’t, you can do it yourself.
Back to Basics
Back To Basics
The majority of us has experienced or knows someone who has suffered through tough economic times that culminated in the fall of 2008. Job losses abound, the stock market is still trying to get back on track and no one knows when it will all get back to “normal”. That’s the bad news. The good news is that we can use this as an opportunity to get our financial house back in order.
The following are the first four financial tasks we must tackle in order to dust ourselves off.
1. Prepare a budget
If preparing a budget seems too daunting and you’ve already given up, then maybe you should work backwards. That is, instead of preparing a budget to see where you could be saving more set up automatic deposits into a savings or retirement account directly from your paycheck every pay period. This way, you do not have to find money to save but instead automatically spend less on the variable expenses we previously mentioned.
2.Pay down debt
Once you have a budget in place and you know where your money is going, you want to set up a plan for paying down debt. Not all debt is bad. Having a mortgage with a reasonable interest rate on a house that is well within your means is not a bad thing. Credit card debt, though, is a different animal all together. Whereas a home is usually an appreciating asset, the purchases you make with a credit card are almost entirely depreciating assets. Think clothing, gadgets, etc.
With the money you “found” from creating a budget and eliminating some of the unnecessary variable expenses, you want to increase the amount you pay on your credit card assuming you have an existing balance and do not pay the amount in full every month. If you have multiple credit cards with outstanding balances, try and pay off the card with the highest interest rate first. This will allow you to “save” money on the interest that compounds every month. Once your first card is paid in full, add the amount you were paying monthly to pay off this card to the amount you pay monthly on the next card with the highest interest rate. Do this exercise until all your credit cards are paid off. Once you are credit card debt free, use the cards only for emergencies and make sure to pay off the balance in full every month.
3. Set up an emergency fund
An emergency fund should contain three to six months worth of expenses in case of, an emergency. Knowing how much you should have in an emergency fund is simple as long as you completed your first goal of setting up a budget. If there are two working spouses at home or one spouse with two jobs or an additional source of income, three months worth is usually acceptable. However, if only one spouse is working and that is the only source of income, you want to strive for six months worth. This money should be liquid and safe. That is, at a bank or credit union, in a savings account or short term CD. The goal here is not for this money to be growing but rather for it to be readily available in case of the unexpected. Do not touch this money for frivolous purchases.
4. Save for retirement
Now that you have gotten out of debt and have put some money aside for a rainy day, it’s time to get serious about your retirement. Gone are the days when an employer pension and Social Security provided for a comfortable retirement. Now it’s up to you to save lavishly and invest prudently to ensure your retirement years will be golden. Your (retirement) savings target should be a minimum of 15% of your gross annual income. However, if you are close to retirement and have saved little over the years or suffered a significant drop in your portfolio from the stock market debacle of late 2008, you will need to save more.
There are a multitude of options available to save for retirement. There are employer sponsored plans such as 401ks and 403bs as well as individual plans such as Roth, Traditional and SEP IRAs (Individual Retirement Accounts). If your employer has a plan in place and matches a percentage of your contribution, you would be foolish not to contribute. The employer match is essentially “free money”. If, on the other hand, you do not have a 401k or 403b option, you could contribute to an Individual Retirement Account (IRA). Although the contribution limits are much smaller for an IRA versus a 401k or 403b, $5,000 and $16,500, respectively, the growth on these investments is still tax deferred.
Regardless of whether you are investing in an employer sponsored plan or an IRA, you want to make sure you diversify your portfolio among domestic and international holdings as well as large and small company stocks. A diversified asset allocation will provide you with a less volatile portfolio that takes advantage of the growth potential across all asset classes.
If you find the 15% of annual gross income to be unattainable, don’t despair. Saving even 5% can make a difference. Once your economic situation improves, increase the amount until you get to 15% or more. Remember, it is better to save more than less. Having more money than you need during retirement is a “problem” we should all aspire to.
Sometimes we need to have the rug pulled out from under us to realize we are going down the wrong path. Gone should be the days of spending more than we make, racking up credit cards, and saving next to nothing for retirement. Let’s use the experiences of the last two years as the catalyst to reassess our financial situation and take the steps to improve upon it. It’s time we get back to basics and live within our means. Frugality is alive and well!
It could be so simple. If average returns were real returns, retirees could assume they would make, say, 10% each year, spend 6%, and count on 4% growth. Alas, returns are highly variable, and the downside—having to sell equity assets in a down market—can be pretty scary. So, as a rule of thumb, investors should keep enough liquid assets to meet all their anticipated needs for at least five and preferably seven years.
As an example, an investor who anticipates needing about 5% of his capital each year should place between 25% and 35% of his investment assets in short-term, high-quality bonds. Retirees with greater or lower cash-flow needs can adjust the minimum bond percentage necessary to meet short-term needs. The rest can, with reasonable safety, be invested for long term growth in a global diversified equity portfolio.
Of course, some retirees will opt for an even more conservative portfolio. That’s all right, up to a point. Sleeping well is a legitimate retirement investment objective. Risk reduction and peace of mind can be well worth the cost.
But the cost of moving from, say, 30% bonds to 40% bonds is a reduction of expected return of about 1% per year. I’m constantly surprised at how many retired investors still are hung up on generating income from their investments. As previously discussed, the old retirement income prescription of bonds, convertible bonds, REITS, utilities, and preferred stocks will indeed generate high levels of income—but at a cost to total return, and with higher risk than is necessary.
The retiree’s best solution is the same as any other investor’s: Invest to meet total-return objectives at the lowest possible risk level. As we have seen, a combination of stocks and bonds dampens volatility, and provides the highest possible probability of success at moderate withdrawal rates. But if bond interest and equity dividends alone are unlikely to meet reasonable income needs, how to generate a reliable cash flow?
To get started, put enough cash in money-market funds to meet your income requirements for the next year. (This cash should be considered part of your bond-fund allocation.) Have all dividends and interest from other investments paid directly to the money-market account, and set up an automatic monthly transfer from this account to your checking account to meet your everyday needs. That’s it for now. Go sailing or play tennis for a year.
At the end of the first year, evaluate your account performance and asset allocation. You’ll need to rebalance your portfolio, while raising cash for the upcoming year. The strategy is simple: Buy low, and sell high. If stocks have done well, sell enough winners to meet your cash needs and then re-balance back to your initial asset-allocation plan. If stocks have done poorly, then just sell enough bonds to meet next year’s needs.
That’s why you should keep five to seven years’ worth of cash set aside in short-term bonds. Those short-term bonds can be a life raft during a storm in the equity markets. Imagine being several years into a bad market and having to start selling stocks. How are you going to feel then? Wouldn’t you rather have a bit much in bonds rather than not enough? Stock-market downturns are temporary, and every previous one, without exception, has been followed by recovery and new highs—but you won’t fully enjoy a rebound if you had to sell out beforehand.
An annual re-balancing forces the sale of the previous year’s winners and the purchase of the past year’s losers. This may be tough to do, because we are naturally emotionally biased toward our current winners and disgusted with poor performers. The longer a specific market trend continues, the harder it is to remember that all equity asset classes (whether large- or small-cap, for example) have good return prospects. While some investments may be trailing, you presumably selected them in part for their low correlation with your other holdings. The temptation to keep winners and dump losers may be strongest just before the trend shifts.
An annual review is greatly simplified for index-fund investors, because they need not be concerned with style drift or management underperformance or changes. Further, investors can expect top-quartile performance relative to active managers, with a great deal more consistency. And index funds are great for taxable accounts, because of their limited turnover relative to managed funds. (If you have both tax-deferred and taxable accounts, you should give serious attention to minimizing both income and estate taxes when setting your withdrawal strategy. Issues such as how to manage mandatory withdrawals at age 70 1/2, whether to convert to a Roth IRA, and what order to draw down your various accounts will have a huge impact on the bottom line both for yourself and your heirs. These situations can be so convoluted that they are often best addressed on an individual basis by a competent tax attorney or CPA.)
If you keep your withdrawals at a “reasonable” level, your portfolio should grow and prosper (unless we have an economic disaster worse than any since the depression). Periodically check in to see if you need to adjust your withdrawals. If all has gone well, you may even be able to give yourself a raise.
Resist the temptation to tinker endlessly with the account. It’s not likely to do you any good. Of course, it is appropriate to alter your asset allocation if you have a major change in objectives or life situation. And very occasionally there is new academic research that reveals a more efficient asset-allocation strategy. But the key phrase is “academic research”, which does not include a Money Magazine interview with this month’s hot small cap manager!
Set your strategy in place, relax, and enjoy your retirement. You deserve it.