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It’s Up to You!
Most American workers are responsible for their own retirement savings. That’s good for news those who understand the investment game; bad news for those who don't.
The problem is most people don’t.
In fact, most of us have never taken classes on personal finance, investing, or preparing for retirement. Those are not required classes in high schools, colleges or places of employment. Yet, employees are expected to figure out what to do with their 401(k) plans or other retirement accounts by themselves.
In this article, we’ll discuss what you need to know to get ready for retirement: (a) the retirement accounts options available to you, (b) your investment options, and (c) how to invest for maximum profit at acceptable risks.
We hope that after reading this article, you’ll know how to get on the right path toward a comfortable retirement, no matter what you do for work, or how much you earn.
The Most Important Thing: Start Now
The most important thing about preparing for retirement is this: Start as early as possible.
In fact, the best day to start saving is today, even if you can save only a little bit.
Why? Three reasons:
1) The power of compound interest,
2) Social security benefits may not be around by the time you retire, and
3) The power of habits.
1.The power of compound interest. You’ve probably read about this before, but the best way to understand it is to see it in front of you.
Note: Assumes 3% annual increases in contribution amounts & 10% average annual returns on investments.
As you can see in the chart above, if (a) you start investing $100 a month at age 25, (b) increase your contributions by 3% each year (must keep up with inflation), and (c) earn 10% average annual returns (which is the long-term historical average of the S&P 500 Index), you will have a balance of $913 thousand upon retirement. If, on the other hand, you until you’re 45, even if you start saving $400 instead of $100, you’ll end up with only about $255 thousand.
Yes, the person who starts earlier wins on both counts: May save less and still finish with much more. It’s that simple.
Now consider these facts:
· People who are alive today can expect to live until age 87;
· The average person spends 22 years in retirement – and advances in healthcare could make that even longer.
· The average monthly Social Security benefit today is only $1,368.
If your earnings have been above average, you'll collect more than that - but the overall maximum monthly Social Security benefit for those retiring at their full retirement age in 2020 is still just $2,687.
Now, how comfortable do you suppose you’ll be able to live on a combined income of between $1,368 and $2,687 (adjusted for inflation) and whatever your savings are at retirement?
Naturally, that will depend on several factors, including whether or not you own your own house at that time, and how healthy you are. But one thing is certain, the more you have saved and invested on your own, the better you’ll live throughout retirement.
2. Social Security Benefits may go away. The Social Security benefits most Americans count on for retirement may be significantly reduced or disappear by the time you get to age 65. The government's official position is that there is enough money saved to pay benefits at the currently scheduled amounts until 2035.
The Social Security Administration admits on its Web site that benefits will likely be reduced after that, barring changes that improve the financial strength of the system.
Social Security’s cash flow has been negative since 2010, meaning that the program has paid out more than it takes in via taxes. Right now, it is covering that shortfall with interest on its Treasuries, but this can’t continue indefinitely.
To close the gap Congress is going to have to scale back benefits for future recipients, increase taxes, or both. Do you really want to depend on Congress to act? …
2. The power of forming good habits. Saving, like so many other good things, are a lot easier to do when they become a habit. No matter how many charts and numbers I show you, if you don’t start to save today, you may never get into the habit of saving. As Warren Buffett put it, “the chains of habit are to light to be felt until they are too heavy to be broker.”
If you don’t start saving even a little today, it will become second nature and you’ll do it automatically without feeling like you’re missing out on some crave for instant gratification.
HOW MUCH SHOULD YOU SAVE?
The simple answer, of course, is “as much as you can.” A good rule of thumb to follow is to save at least 10% of your income. But life being as it is, not everyone can save 10%. The key is to start with something, say 2% deducted from your paycheck or $50 automatically deducted from your bank account. Once you start saving, it’ll be easier to increase the amount each year.
Retirement Account Options
Now that you’ve made the right choice in deciding to save for retirement, make sure you are taking full advantage of the tax savings options available to you.
Start with your employer. Your employer’s retirement savings plan is an essential part of your future financial security. It is important to understand how your plan works and what benefits you will receive. Just as you would keep track of money that you put in a bank or other financial institution, it is in your best interest to keep track of your retirement benefits.
Those responsible for the management and oversight of your retirement plan must follow certain rules for operating the plan, handling the plan’s money, and overseeing the firms that manage the money. You should also understand and monitor your retirement plan and your benefits. So let’s go through the basics.
Your account options will depend in large part on where and how you work. So the first step to understanding your retirement benefits is to find out what kind of retirement plan your employer has.
TYPES OF RETIREMENT PLANS
There are two major types of plans, defined benefit and defined contribution.
Keep in mind that your employer may have more than one type of plan, and may have different participation requirements for each. A defined benefit plan, funded by the employer, promises you a specific monthly benefit at retirement.
The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more often, it may calculate your benefit through a formula that includes factors such as your salary, your age, and the number of years you worked at the company. For example, your pension benefit might be equal to 1 percent of your average salary for the last 5 years of employment times your total years of service.
A defined contribution plan, on the other hand, does not promise you a specific benefit amount at retirement. Instead, you and/or your employer contribute money to your individual account in the plan. In many cases, you are responsible for choosing how these contributions are invested, and deciding how much to contribute from your paycheck through pretax deductions. Your employer may add to your account, in some cases by matching a certain percentage of your contributions. The value of your account depends on how much is contributed and how well the investments perform. At retirement, you receive the balance in your account, reflecting the contributions, investment gains or losses, and any fees charged against your account. The 401(k) plan is a popular type of defined contribution plan. There are four types of 401(k) plans: traditional 401(k), safe harbor 401(k), SIMPLE 401(k), and automatic enrollment 401(k) plans. The SIMPLE IRA plan, SEP, employee stock ownership plan (ESOP), and profi t sharing plan are other examples of defined contribution plans. (See explanations of the various types of plans in the Glossary at the end.)
IF YOU WORK AT A FOR-PROFIT EMPLOYER
Available account: 401(k) plan.
If your for-profit employer offers any workplace retirement savings plan, it’s probably a 401(k). (Many smaller employers do not.) You can generally sign up for this any time (not just during your first week on the job or during specific periods each year). All you have to do is fill out a form saying what percentage of your paycheck you want to save, and your employer will deposit that amount with a company (like Fidelity or Vanguard) that will hold it for you.
Here, automation is your friend. Some employers will automatically raise your savings rate each year, if you let them. And you should.
Things to Know About a 401(k)
Matching: If you’re really lucky, your employer will match some of your savings. It may match everything you save, up to 3 percent of your salary. Or it may put in 50 cents for every dollar you save, up to 6 percent of your salary. Whatever the offer is, do whatever you can to get all of that free money. It’s like getting an instant raise, one that will pay you even more over time thanks to the compound interest we were talking about before.
Caps: How much can you put aside in a 401(k)? The federal government makes the call on this, and it often goes up a bit each year. You can find the latest numbers here.
Taxes: As with most other employer-based plans, when you save in a 401(k) you don’t pay income taxes on the money you set aside, though you’ll have to pay taxes when you eventually take out the money.
IF YOU WORK AT A NONPROFIT EMPLOYER
Available accounts: 401(k), 403(b) and 457 plans.
If you work for the government or for a nonprofit institution like a school, religious organization or a charity, you likely have different options.
What to Know About a 457 plan: These are a lot like 401(k)’s, so read the section above to understand them better.
What to Know About a 403(b) plan: These frequently show up at nonprofits – 401(k)’s are more rare here – and often get complicated and expensive. You may be encouraged (or forced) to put your money into an annuity instead of a mutual fund, which is what 401(k) plans invest in. (More on mutual funds later.) Annuities technically are insurance products, and they are very difficult even for professionals to decipher. Which brings us to the expensive part: They often have very high fees.
In some instances, especially if your employer is not matching your contribution, you may want to skip using 403(b)’s altogether and instead use the I.R.A.s we discuss below.
ACTION ITEM
Ask your plan administrator, human resources office or employer for information on what type of plan or plans you have at work. You can ask for a copy of the Summary Plan Description (the retirement plan booklet that you should receive when you enroll in the plan) and review the information about the plan.
IF YOUR EMPLOYER OFFERS NO PLAN OR YOU’RE SELF-EMPLOYED
Available accounts: I.R.A., Roth I.R.A., S.E.P. and Solo 401(k) plans.
People who are setting up their own retirement accounts will usually be dealing with I.R.A.s, available at financial-services firms like big banks and brokerages.
What to Know About I.R.A.s:
Choosing where to start an I.R.A.: Ask the financial institution for a complete table of fees to see how they compare. How high are the fees to buy and sell your investments? Are there monthly account maintenance fees if your balance is too low?
In general, what you invest in tends to have far more impact on your long-term earnings than where you store the money, since most of these firms have pretty competitive account fees nowadays.
As with 401(k)’s, there may be limits to the amount you can deposit in an I.R.A. each year, and the annual cap may depend on your income and other circumstances. The federal government will adjust the limits every year or two. You can see the latest numbers here.
Taxes: Perhaps the biggest difference between I.R.A.s has to do with taxes. Depending on your income, you may be able to get a tax deduction for your contributions to a basic I.R.A. up to a certain dollar amount each year. Again, check the up-to-date government information on income and deposit limits and ask the firm where you’ve opened the I.R.A. for help. After you hit the tax-deductible limit, you may be able to put money into an I.R.A. but you won’t get any tax deduction. As with 401(k)’s, you’ll pay taxes on the money once you withdraw it in retirement.
What to Know About Roth I.R.A.s:
The Roth I.R.A. is a breed of I.R.A. that behaves a little differently. With the Roth, you pay taxes on the money before you deposit it, so there’s no tax deduction involved upfront. But once you do that, you never pay taxes again as long as you follow the normal withdrawal rules. Roth I.R.A.s are an especially good deal for younger people with lower incomes, who don’t pay a lot of income taxes now. The federal government has strict income limits on these kinds of everyday contributions to a Roth. You can find those limits here.
What Are S.E.P.s and Solo 401(k)s?
Another variation on the I.R.A is aS.E.P. (which is short for Simplified Employee Pension), and there is also a Solo 401(k) option for the self-employed. They came with their own set of rules that may allow you to save more than you could with a normal I.R.A. You can read about the various limits via the links above.
WHAT HAPPENS IF YOU CHANGE JOBS?
When you leave an employer, you may choose to move your money out of your old 401(k) or 403(b) and combine it with other savings from other previous jobs. If that’s the case, you’ll generally do something called “rolling the money over” into an I.R.A. Brokerage firms offer a variety of tools to help you do that, and you can read more about the process here.
That said, some employers will try to talk you into leaving your old account under their care, while new employers may try to get you to roll your old account into their plan. Why do they do this? Because the more money they have in their accounts, the less they have to pay in fees to run the program for all employees.
But leaving your money behind or rolling it into your new employer’s plan may have disadvantages. Most employer plans may have only a limited menu of investments, but your I.R.A. provider will generally let you invest in whatever cheap index funds you want.
Also, it’s generally best to keep all of your retirement money in one place; it’s easier to keep track of it that way. So, roll all your retirement accounts into an I.R.A. once you leave a company to simplify things, especially as you near retirement. You can’t count on former employers to keep in touch as your home or email addresses change. Nor will every entity that has an account in your name necessarily track you down when you near retirement.
How to Invest Your Money
You don’t need to be financially savvy to make smart investment decisions.
Dozens of books exist on the right way to invest. Thousands of people spend their careers suggesting that they have the best formula. So let us try to cut to the chase with a simple formula that should help you do just fine as long as you save enough.
Be humble.
Humility comes first. Do you fix your own car? or do your own dentistry? Then why would you want to handle your own investments?
Unless you feel that you really are an investment guru, your best course of action is to find an advisor with an investing approach, fees and incentives you understand and let them take care of it for you.
Even great actors have acting couches, and even lawyers (the sensible ones) hire other lawyers to do their legal work for them. Investing your money is something that should be handled by experts. Find the one that best suits your temperament, and let them handle it for you.
Do Semiannual Checkups
Once you hire an investment adviser to manage your money for you, there are two things you shouldn't do: (1) set it and forget it, or (2) check your accounts everyday.
Don't just set it and forget it. It's your money, so you should get a review at least twice a year. A good adviser will send you reports and update on their thinking at least semi-annually.
Checking your investments too often can he hazardous to your financial health. That's because investments go up or down every day, and with all the noise the media loves to make about financial markets, you'll be tempted to change course every time you check. We're only human, and our emotions will get on the way of rational investment decisions if we pay too much attention to our investment accounts. So don't.
Take Action Now
1. Commit to Saving an additional 1% More from Your Paycheck
Time required: 5 minutes
First of all, if you have not set up a retirement account, take 5 minutes right now and do it.
Go ahead, we'll wait ....(Open an IRA Here)
Now, if you followed our earlier advice, you set it up so you have money automatically taken out of each paycheck for your retirement account. You'll barely miss it. So increasing your savings by another percentage point probably won’t hurt your budget much. Over time, it could add up to six figures in additional savings.
2. Reconsider Your Priorities
Time required: 15 minutes
Are you saving enough for retirement? how about for your children’s college tuition?
Saving for a down payment on a home or a great vacation is important, but both may be able to wait, and it’s easier to borrow money for a child’s education than it is to get loans to pay for your retirement expenses. Make sure you are investing wisely, for the most important things.
3. Rethink Your Investment Strategy
Time required: 30 minutes
It’s been a great decade for the S&P 500 index - until the coronavirus crisis surprised us all. So if you set up accounts some years ago, and like almost everyone else, all your money is invested in index funds, it's time to rethink your strategy. The "indexing revolution" may be starting to get overdone and it's due for a correction. Don't wait until panic hits and everyone tries to get out of index funds at the same time.
Start selling some funds and putting your money in more carefully selected group of stocks. Consider putting some money in an Abbilon Managed Account.