A couple of weeks ago, I wrote about the “Tyranny of the 401(k) Industry Complex.” The post was a commentary on an episode of PBS's “Frontline,” which argued that the current defined-contribution retirement system is failing the country; financial-services companies make money while working Americans don't, partially because these workers are getting ripped off, but also because the average American doesn't have the time, skills, or inclination to manage their own retirement planning.
There was a good amount of debate in the comments section about whether retirement planning is all that difficult. I can see both sides, but in this post, I want to make it as simple as possible. If you follow this advice, you'll be taking some big steps in the right direction. It's not a perfect plan for each individual — feel free to add your own tips below — but it's a solid strategy for those who have been frozen by “analysis paralysis” and have put off saving for retirement out of fear of making big mistakes.
Step 1: Save at least 10 percent to 15 percent of income, more if you're starting late
The typical American is saving around 7 percent or 8 percent; that won't be enough, especially for those who didn't begin saving in their 20s. To help workers determine a good savings rate, the super-smart folks at Morningstar's Ibbotson Associates came up with some good guidelines. Their assumptions:
- Retire at 65
- No cuts in Social Security benefits (Yes, it's very possible that benefits will be cut, but most people should also retire later than age 65.)
- Inflation at 2.5 percent
- Income needed in retirement is 80 percent of pre-retirement income after retirement savings (e.g., if your household income is $100,000 a year, and you save $10,000 a year, your required retirement income is 80 percent of $90,000, or $72,000)
It's an 11-page document full of fun (or not) charts, but since we're trying to keep this simple, here's a sample:
|Age||Income||Savings Rate||Reduction for each $10,000 of portfolio|
|25||$80,000||11.2 percent||0.40 percent|
|35||$100,000||17.6 percent||0.57 percent|
|45||$120,000||28.2 percent||0.31 percent|
Here's an example of how to use this: A 35-year-old who has already accumulated $50,000 would subtract 2.85 percent (5 x 0.57 percent) from 17.6 percent, resulting in a savings rate of 14.75 percent.
Keep in mind that your savings rate includes an employer match to your 401(k) contributions, if you're lucky enough to have one. So if your employer matches 50 cents on the dollar up to a contribution rate of 6 percent, and you contribute 10 percent of your salary to your retirement plan, your actual savings rate is 13 percent.
All that said, if even looking at that chart makes you want to run away to Facebook, just do this for now: Save 10 percent to 15 percent of your salary if you're in your 20s or early 30s, and bump it up five percentage points for every five years you delay saving. Yes, that might be more saving than you're capable of. I'll address that in my next post.
Step 2: Choose the traditional 401(k), then the Roth IRA
Another speed bump along the road to retirement savings is the decision between a traditional and Roth account. The easy solution: Choose both. Use the 401(k) up until you take full advantage of the match, then use a Roth IRA for the rest. Two benefits: You're getting “tax diversification” by having both types of accounts, and you're not putting all your eggs in the 401(k) basket. The latter benefit is partially what that “Frontline” episode discussed. The sad truth is, many employer-sponsored retirement accounts stink. But opening an IRA with a mutual fund company or discount broker gives you more choices at better prices.
Of course, choosing an IRA provider and opening the account is itself a speed bump. So start immediately contributing to your 401(k), then resolve to do the Roth IRA thing later. But if you know you won't do it (self-awareness is a virtue!) then just get it all in the 401(k) — especially if you earn too much to contribute to a Roth IRA. (For 2013, the eligibility to make contributions phases out for single taxpayers with a modified adjusted gross income of $112,000 to $127,000, and 178,000 to $188,000 for married couples.)
Step 3: Choose a target retirement fund
Once you get your money into the account, you have to decide how to invest it. The easy answer: a target retirement mutual fund, which invests your money with a general retirement date in mind. The name of the fund always includes a year, and you choose the fund with the year closest to when you think you'll retire. Based on that time horizon, the fund manager chooses an appropriate asset allocation — some U.S. stocks, some international stocks, some bonds, some cash — and then rebalances the portfolio for you, making the fund more conservative as the target date approaches. It's essentially a one-stop-shop for hands-off investors.
While investing in just one fund may sound too risky, a target date fund is actually a “fund of funds” – i.e., a mutual fund that owns many other funds. Let's look at an example. Consider the T. Rowe Price 2040 fund, a fine choice for people who aim to retire in 25 to 30 years. It owns the following funds (according to Morningstar):
|Fund||Percent of 2040 Fund|
|T. Rowe Price Growth Stock||22.85|
|T. Rowe Price Value||20.71|
|T. Rowe Price Equity Index 500||7.48|
|T. Rowe Price International Stock||7.16|
|T. Rowe Price Intl Growth & Income||7.07|
|T. Rowe Price Overseas Stock||6.86|
|T. Rowe Price New Income||5.36|
|T. Rowe Price Emerging Markets Stock||4.82|
|T. Rowe Price Mid-Cap Growth||3.57|
|T. Rowe Price Real Assets||3.56|
|T. Rowe Price Mid-Cap Value||3.43|
|T. Rowe Price New Horizons||1.59|
|T. Rowe Price Small-Cap Stock||1.57|
|T. Rowe Price Small-Cap Value||1.54|
|T. Rowe Price High-Yield||0.89|
|T. Rowe Price Emerging Markets Bond||0.89|
|T. Rowe Price International Bond||0.68|
Given that the year 2040 is a few decades away, this target retirement fund is mostly invested in stocks. As 2040 gets closer, the fund will gradually move from stocks to bonds all on its own. You don't have to do anything.
Now, two caveats about target retirement funds:
- Like all investments, they'll drop in value. The T. Rowe Price 2040 fund dropped 38.9 percent in 2008, when the S&P 500 dropped 37.0 percent.
- Investing in a target retirement fund doesn't guarantee you'll be able to retire on the target date. You still have to make sure you're saving enough.
Step 4: As you get closer to retirement, monitor progress
Once you reach your 40s — and certainly your 50s, and definitely right before you retire — you need to do some number-crunching to make sure you're on track.
You can use an online retirement calculator, and fiddle with the variables to see what has the biggest impact on your chances of success. You can also hire a financial planner who charges by the hour (such as some of the folks at the Garrett Planning Network and NAPFA) to give you an objective, professional analysis.
A fine start, but…
Voltaire is credited with the quote “perfect is the enemy of good.” Don't put off saving for retirement until you know everything and feel that your plan will be perfect. After all, “perfect” retirement plan doesn't exist, partially because there are too many variables that you don't have control over (e.g., investment returns, inflation, the future of Social Security). But you can increase your chances of success. The advice in this post will get you going in the right direction. Put these wheels in motion, then take time to learn more and customize the plan for your situation. Maybe you need to save more or less. Maybe you can do better than a target retirement fund. Maybe you should have all your money in a Roth. The good news is, none of this is set in stone. Just start doing something now, and change later as you learn more.