Retirement planning is one broad topic, and it is basically difficult to cover everything about retirement in one great article. An article that tries to summarize this topic is a must read, and as I promised yesterday, here is the second part of Retirement Planning by Jonas Elmerraji, that we were talked about.
Building A Nest Egg
There are a myriad of investment accounts, savings plans and financial products you can use to build your retirement nest egg. Many countries have government-sanctioned retirement accounts that provide for tax-deferral while your savings are growing in the account, thus postponing taxation of your investment earnings until you withdraw your funds for retirement.
Due to the wide array of savings methods available (each with their own pros and cons), and the fact that each individual will have a different solution based on his or her circumstances and personal preferences, it would be impractical to discuss each in detail.
That said, there are financial goals and strategies common to pretty much everyone, and a core group of investment vehicles available to most as well. A quick overview of the tools at your disposal and the characteristics of each will help you determine what route is best for you. If you feel you need assistance choosing the financial vehicles with which to build your nest egg, consider consulting with a professional financial planner.
Most governments of developed countries provide a legal framework for individuals to build retirement savings with tax-saving advantages. Due to the advantages these investment accounts offer, there are usually limits regarding contribution amounts and age limits at which you will stop enjoying the benefits of those savings plans.
It’s generally advisable for you to exhaust the contribution room you have for your government-sponsored accounts before you begin looking at other avenues, as whatever securities you invest in are more likely to deliver enhanced returns through compounding of tax-sheltered earnings or otherwise beneficial accounts.
Here’s a breakdown of the government-sponsored investment accounts available to most people:
A 401(k) plan is a voluntary investment account offered to employees by their company. The plan allows up to a certain percentage of your pre-tax employment income to be contributed to your 401(k) account. This means that you do not have to claim the portion of income you route to 401(k) as employment income for the year it is earned. As well, all investment gains you reap from the funds invested in your 401(k) are not taxable as long as they remain in the fund.
401(k) plans, and the percentage of earnings they allow to be contributed, vary from company to company. Check with your employer to learn the details of the 401(k) plan applicable to you. What securities your 401(k) funds can be invested in varies from company to company as well – some employers require that you choose from a list of approved mutual funds or similar securities, while others allow you more latitude to choose your investments.
Check with your employer to see what 401(k) options you have available and consider using the 401(k) as one of your key retirement savings vehicles. The benefits of the tax-deferral it provides can add up to substantial tax savings over long periods of time and go a long way to boosting the size of your nest egg.
An IRA, or individual retirement account, is a retirement savings account that allows an individual to make an annual contribution of employment income, up to a specified maximum amount. Similar to a 401(k), your IRA contributions can lower your taxable income, and capital gains are tax-deferred until you begin withdrawing your funds as income.
The rules for IRAs, and whether your contributions are tax-deductible, vary according to income levels and other factors, such as the type of IRA and whether you participate in an employer-sponsored retirement plan. Generally speaking, however, IRAs offer the opportunity for tax-rate optimization, since most individuals fall into lower tax brackets during their retirement years. By postponing taxation on funds you contribute to your IRA, not only are you likely to be taxed later in time, you can also enjoy a lower rate of taxation on your funds, and with Roth IRAs, your savings can even accumulate on a tax-free basis. There are many different types of IRA accounts that have been offered over the years.
If you need help assessing what type of IRA account is best for your needs, consider consulting with a professional financial planner. For Canadian citizens, the RRSP account is essentially the equivalent of an IRA.
Company Pension Plans
While private businesses have shifted from offering defined-benefit pension plans to other forms of employer-sponsored plans, such as defined contribution plans, there are still plenty that do offer defined-benefit plans to employees. Let’s take a brief look at the key differences:
A defined-contribution plan can be a money-purchase pension plan or profit-sharing plan, in which only your employer makes contributions, or a 401(k) plan where you contribute amounts from your paycheck and your employer may also make contributions.
For a defined-benefit pension plan, your employer usually makes periodic contributions, and a specified amount of funds is deposited into the plan every month.
Regardless of the form of payment you receive, the value you get from a defined-contribution plan depends on how much money is put in over time and the returns its investments generate. Should your plan’s investments perform well, you will accrue the benefits. Likewise, you bear the risk of poor market performance. With a defined-contribution plan, your contributions are certain (i.e., they are defined), but the eventual size of your nest egg is not guaranteed.
This contrasts with the structure of a defined-benefit plan, in which your employer uses a formula to calculate a specific monthly retirement allowance you’ll receive when you retire. Like a defined-contribution plan, these plans also require monthly contributions, which can come from your paycheck, your employer or some combination of both.
Typically, defined-benefit plans calculate your benefits based on factors such as the number of years you’ve been a member of the pension plan, your average (or perhaps peak) salary, your retirement age, etc.
The key difference here is that, with a defined-benefit plan, your employer essentially guarantees that you will receive a certain amount of money each month for the rest of your retired life. Regardless of whether the capital markets do well or poorly, your employer is bound by the terms of the plan to provide your monthly pension amount to you as calculated by the formula. If the stock market crashes, your benefits remain the same. On the flip side, good returns enjoyed by the pension fund do not accrue to you – if the stock market does very well, you do not reap the benefits, and your pension remains the same.
Either type of plan can provide you with a reasonable retirement, but be aware of the differences between the two. If your employer offers both, the eligibility requirements will determine which of the plans you are allowed to participate in.
There are a host of other retirement vehicles available as well. For example, retirees are able to purchase annuities through insurance companies, which essentially provide them with a defined pension for the rest of their lives, or for a fixed period. There are many different annuity types and various options for each, so if you are considering this route, be sure to carefully assess your options.
There are many other investment products that may or may not be useful for you, depending on your individual circumstances. Term life insurance can be an effective way to guarantee that your spouse or loved ones will have a sufficient nest egg if you suffer an accident or early death and cannot continue earning income to contribute to your retirement fund.
Generally, you may need life insurance if you are the primary breadwinner in the family and you need to ensure your income will be replaced should you pass away. Term life insurance is usually limited to income replacement, while whole life insurance also includes an investment component and builds cash value against which you can take a loan out. Whole life is usually a lot more expensive, and some financial professionals project that it may be wiser to purchase term life and use the extra funds to fund a retirement plan. Before purchasing any form of life insurance, consult with your financial planner to ensure you purchase the insurance that is right for you.
There are also long-term care and medical cost plans that can be tailored to specifically ensure that significant medical expenses won’t affect your retirement years. All of these types of products can be useful, but it is unlikely that all of them are needed. Consider consulting with a professional financial planner to help determine what specialized products may be required or useful for your retirement plan.
Whether it’s 401(k)s, IRAs, company pension plans, or some other combination of those vehicles and financial products, all are ways to put your monthly retirement fund contributions to work. Once you determine what amount of monthly savings you want to contribute to your plan, determine which investment vehicles you have at your disposal and select those that best fit your financial profile.
Tax Implications and Compounding
The Early Bird Gets … the Nest Egg
While it’s not difficult to understand that building a sufficient retirement fund takes more than a few years’ worth of contributions, there are some substantial benefits to starting your retirement savings plan early.
One of the most important determinants impacting how large your nest egg can get is the length of time you let your savings grow. The reason for this is that the effects of compounding can become very powerful over long periods of time, potentially making the duration of your retirement savings plan a much more critical factor than even the size of your monthly contributions.
The bottom line is if you don’t start saving for retirement early on in your working life, it will be more costly trying to play catch-up later on. It’s much easier to put aside a small amount of money each month starting from a young age than it is to put aside a large amount of money each month when you are older. Unless you have other serious financial pressure to take care of, such as a lot of credit card debt, you should seriously consider starting to save for your retirement as early as possible.
Compounding Your Tax Savings
The power of compounding works when it comes to taxes, too. As we mentioned earlier, it’s important that you use government-sponsored investment accounts (such as IRAs) as much as possible while carrying out your retirement plan, since they will usually afford tax-deferred benefits.
What may surprise you, however, is how substantial the effects of deferring taxes can be over the long-term. Again assuming an annual 15% growth rate on investments and 20% tax on capital gains and investment income, the example below details just how much value there is in deferring your taxes for as long as possible.
Consider two investments of $1,000 invested for 30 years, one in a tax-deferred account and the other in a taxable account. Assume that taxes are paid each year on all capital gains in the taxable account. The end result after 30 years is that taxes leave the taxable investment’s size at about half that of the tax-deferred account.
Of course, this example is based on the assumption that the taxable investment account turns over its portfolio each and every year (i.e., 20% capital gains tax rate is applied to all capital gains each year). If the taxable portfolio held on to stocks for the long-term, for example, the capital gains taxes would be delayed.
Regardless, it is usually not beneficial to incur taxes sooner, as opposed to later, and this example should make it clear that failing to take advantage of the tax-sheltering options available could be very costly.
The Bottom Line
Begin saving for retirement as early as possible and take full advantage of whatever tax-sheltering opportunities are available for as long as you can.
Asset Allocation and Diversification
So far, we’ve gone through how to determine what you’ll need for retirement, where you can get your retirement savings from, what types of investment accounts you can put your savings into and the benefits of long-term and tax-efficient investing. After all this you may now be asking yourself, “What the heck do I invest in?”
It isn’t practical to discuss in detail the wide array of securities and investing strategies available in the market today, but we will go over the basics you’ll need to know to set up your retirement investments.
If you feel you need assistance understanding and selecting securities to invest in, consider seeking the help of a professional financial planner.
The assets you choose to invest in will vary depending on several factors, primarily your risk tolerance and investment time horizon. The two factors work hand in hand. The more years you have left until retirement, the higher your risk tolerance.
If you have a longer-term time horizon, say 30 years or more until retirement, investing all of your savings into common stocks is probably a reasonable idea. If you are nearing your retirement age and only have a few years left, however, you probably don’t want all of your funds invested in the stock market. A downturn in the market a year before you are all set to cash out could put a serious damper on your retirement hopes. As you get closer to retirement, your risk tolerance usually decreases; therefore, it makes sense to perform frequent reassessments of your portfolio and make any necessary changes to your asset allocation.
Generally speaking, if you have a limited time horizon, you should stick with large-cap, blue chip stocks, dividend-paying stocks, high-quality bonds, or even virtually risk-free short-term Treasury bills, also called T-bills.
That said, even if you have a long-term time horizon, owning a portfolio of risky growth stocks is not an ideal scenario if you’re not able to handle the ups and downs of the stock market. Some people have no problem picking up the morning paper to find out their stock has tanked 10 or 20% since last night, but many others do. The key is to find out what level of risk and volatility you are willing to handle and allocate your assets accordingly.
Of course, personal preferences are second to the financial realities of your investment plan. If you are getting into the retirement game late, or are saving a large portion of your monthly income just to build a modest retirement fund, you probably don’t want to be betting your savings on high-risk stocks. On the other hand, if you have a substantial company pension plan waiting in the wings, maybe you can afford to take on a bit more investment risk than you otherwise would, since substantial investment losses won’t derail your retirement.
As you progress toward retirement and eventually reach it, your asset allocation needs will change. The closer you get to retirement, the less tolerance you’ll have for risk and the more concerned you’ll become about keeping your principal safe.
Once you ultimately reach retirement, you’ll need to shift your asset allocation away from growth securities and toward income-generating securities, such as dividend-paying stocks, high-quality bonds and T-bills.
The Importance of Diversification
There are countless investment books that have been written on the virtues of diversification, how to best achieve it and even ways in which it can hinder your returns.
Diversification can be summed in one phrase: Don’t put all of your eggs in one basket. It’s really that simple. Regardless of what type of investments you choose to buy – whether they are stocks, bonds, or real estate – don’t bet your retirement on one single asset.
As you contribute savings to your retirement fund month after month, year after year, the last thing you want is for all your savings to be wiped out by the next Enron. And if there’s anything we have learned from the Enrons and Worldcoms of the world, it’s that even the best financial analysts can’t predict each and every financial problem.
Given this reality, you absolutely must diversify your investments. Doing so isn’t really that difficult, and the financial markets have developed many ways to achieve diversification, even if you have only a small amount of money to invest.
Active Vs. Passive Management
Consider buying mutual funds or exchange-traded funds (ETFs), if you are starting out with a small amount of capital, or if you aren’t comfortable with picking your own investments. Both types of investments work on the same principle – many investors’ funds are pooled together and the fund managers invest all the money in a diversified basket of investments.
This can be really useful if you have only a small amount of money to start investing with. It’s not really possible to take $1,000, for example, and buy a diversified basket of 20 stocks, since the commission fees for the 20 buy and 20 sell orders would ruin your returns. But with a mutual fund or ETF, you can simply contribute a small amount of money and own a tiny piece of each of the stocks owned by the fund. In this way, you can achieve a good level of diversification with very little cost.
There are many different types of mutual funds and ETFs, but there are two basic avenues you can choose: active management and passive management. Active management refers to fund managers actively picking stocks and making buy and sell decisions in attempt to reap the highest returns possible.
Passive management, on the other hand, simply invests in an index that measures the overall stock market, such as the S&P 500. In this arrangement, stocks are only bought when they are added to the index and sold when they are removed from the index. In this way, passively managed index funds mirror the index they are based on, and since indexes such as the S&P 500 essentially are the overall stock market, you can invest in the overall stock market over the long-term by simply buying and holding shares in an index fund.
If you do have a sizable amount of money with which to begin your retirement fund and are comfortable picking your own investments, you could realistically build your own diversified portfolio. For example, if you wanted to invest your retirement fund in stocks, you could buy about 20 stocks, a few from each economic sector. Provided none of the companies in your portfolio are related, you should have a good level of diversification.
The bottom line is, no matter how you choose to diversify your retirement holdings, make sure that they are properly diversified. There is no exact consensus on what number of stocks in a portfolio is required for adequate diversification, but the number is most likely greater than 10, and going to 20 or even a bit higher isn’t going to hurt you.
Troubleshooting and Catching Up
As you build your retirement fund, you’ll likely experience some bumps in the road along the way. One of the most common problems you’ll encounter is an inability to make your monthly retirement contributions. A number of financial pressures can arise to make the process difficult, but fortunately there are ways that you can tilt the odds in your favor.
First of all, set up automatic payments from your checking account (your bank should be able to help you do this) into the investment account you are building your retirement fund with. This is commonly referred to as “paying yourself first”. Once it’s set up, each time you get your paycheck, your desired savings contribution will go right out to your investment account before you have a chance to spend it.
Additionally, if you participate in a 401(k) plan, try to make the maximum salary deferral contribution allowed. If your employer offers a matching contribution, at least try to contribute enough to ensure you receive the maximum matching contribution.
Automatic savings will make it a lot easier to avoid spending your contributions on things you can realistically do without. And if serious financial problems do crop up that require the use of your investment funds, you can usually access those that are deposited to an after-tax account without incurring penalties. The point of the automatic contribution is to avoid any instances of spending too much and missing out on your contributions unnecessarily.
If you do dig yourself into a deep hole of credit card debt, however, it’s important you deal with the problem as quickly as possible. Create a feasible budget to pay down your debt and stick to it. Consider consolidating your debts into one account – this can lower your overall interest rate and help you pay off those debts quicker.
Other problems may crop up, but provided you’re able to maintain your monthly contributions, you should be in good shape. If you are having prolonged difficulty following your plan, consider seeking the help of a financial planner.
What If I’m Late Getting Into the Game?
If you are beginning your retirement savings late in life, you will need to work hard to catch up. The first thing you can do is create a budget for your current expenses so that you can maximize monthly contributions to your retirement fund. With budgeting, a little goes a long way, and if you track your expenses for a month you will likely find that skipping the occasional dinner out can save you hundreds of dollars, which can go a long way to boosting your retirement savings. The main goal is to ramp up your savings rate as much as possible.
You might also consider alternative ways to boost your financial situation. Second jobs are an option, but not a particularly pleasant one. If you own your own home, consider renting out the basement or taking on a roommate in order to lower your living expenses. Converting part of your residence into an income-generating asset can do wonders for your overall retirement plan.
Once again, part-time jobs during retirement can be a feasible way to catch up. If you’re able to earn a modest income during your retirement years, your financial picture can change drastically – especially if you are an active type of person. You may actually prefer semi-employment during your golden years instead of 100% leisure time.
Your Home May Be a Source of Funding for Your Retirement
If you own a home, it could serve as one of the means of financing your retirement – either by selling it and moving to a smaller, less expensive home or by using a reverse mortgage. A reverse mortgage allows you to convert a portion of the equity in your home to tax-free income while retaining ownership (of the home). A reverse mortgage can be paid to you as a lump sum, as a line of credit and/or as fixed monthly payments. If you decide to pursue a reverse mortgage, be sure to factor in the costs, which are similar to those that would usually apply when a house is being purchased. This includes origination fees and appraisal fees.
While it’s impossible to learn everything you’ll ever need to know about retirement planning in a single tutorial, the ground we’ve covered here should give you a solid start.
Retirement planning is an ongoing, lifelong process that takes decades of commitment in order to receive the final payoff. The idea of accumulating hundreds of thousands of dollars in a retirement nest egg certainly can seem intimidating, but as we outlined in this tutorial, with a few basic calculations and commitment to a feasible plan, it’s not difficult to achieve.