Retirement planning is the process of identifying your long-term income, determining your intended lifestyle and defining how to reach those goals. When planning for retirement, you’ll need to consider a variety of factors, such as when you’ll retire, where you’ll live and what you’ll do. Keep in mind that with each additional year you hope to retire early, your investment needs greatly increase. Also consider the difference in cost of living among cities, or even among neighboring ZIP codes. Add on daily expenses, medical expenses, vacations and emergencies, and you begin to see how the costs of retirement add up.
Your retirement goals will depend largely on the income you can expect during your retirement and will likely evolve as your plans, risk tolerance and investment horizon change. While specific investing “rule of thumb” guidelines – such as “You need 20 times your gross annual income to retire” or “Save and invest 10% of your pretax income” – are helpful, it’s important to step back and look at the big picture. Consider these six essential rules for smart retirement investing.
You can save for retirement in a variety of tax-deferred vehicles, some offered by your employer and others available via a brokerage firm or bank. It’s important to take advantage of all your options, including investigating what kind of retirement benefits your employer may provide; some rare employers still offer defined benefit pensions, which can be a big bonus during a time of volatility in the stock market.
When building your portfolio in a retirement account, it’s important to understand the risk-reward relationship when choosing your investments. Younger investors may focus on higher risk–higher reward investments, such as stocks, because they have decades left to recover from losses. People nearing retirement, however, are less able to recover and therefore tend to shift their portfolios toward a higher proportion of lower risk–lower reward investments, such as bonds. Retirement vehicles and common portfolio investments include:
No matter what you read about retirement investing, one piece of advice stays the same: Start early. Why?
Remember that compounding is most successful over longer periods of time. Here’s an example to illustrate: Assume you make a single $10,000 investment when you are 20 years old and it grows at 5% each year until you retire at age 65. If you reinvest your gains (this is the compounding), your investment would be worth $89,850.08.
Now imagine you didn’t invest the $10,000 until you were 40. With only 25 years to compound, your investment would be worth only $33,863.55. Wait until you’re 50 and your investment would be valued at just $20,789.28. This is, of course, an overly simplified example that assumes a constant 5% rate without taking taxes or inflation into consideration. It’s easy to see, however, that the longer you can put your money to work, the better. Starting early is one of the easiest ways to ensure a comfortable retirement.
You make money, you spend money. For many this is about as deep as their understanding of cash flow gets. Instead of making guesses about where your money goes, you can calculate your net worth, which is the difference between what you own (your assets) and what you owe (your liabilities). Assets typically include cash and cash equivalents (for example, savings accounts, Treasury bills, certificates of deposit), investments, real property (your home and any rental properties or a second home) and personal property (such as boats, collectibles, jewelry, vehicles and household furnishings). Liabilities include debts such as mortgages, automobile loans, credit card debt, medical bills and student loans. Adding up all of your assets and subtracting the sum of your liabilities leaves you with the total amount of money you actually possess (your net worth) and a clear view of how much money you’ll need to earn to reach your goals.
As soon as you have assets and liabilities, it’s a good time to start calculating your net worth on a regular basis (yearly works well for most people). As your net worth represents where you are now, it’s beneficial to compare these figures over time. Doing so can help you recognize your financial strengths and weaknesses, allowing you to make better financial decisions in the future.
It’s often said that you can’t reach a goal you never set, and this holds true for retirement planning. If you fail to establish specific goals, it’s difficult to find the incentive to save, invest and put in the time and effort to ensure you are making the best decisions. Specific and written goals can provide the motivation you need. Examples of written retirement goals:
Investments can be influenced by your emotions far more easily than you might realize. Here’s the typical pattern of emotional investment behavior.
When investments perform well:
When investments perform badly:
Emotional reactions can make it difficult to build wealth over time, as potential gains are sabotaged by overconfidence, and fear makes you sell (or not buy) investments that could grow. As such, it is important to:
While you are likely to focus on returns and taxes, your gains can be drastically eroded by fees. Investment fees cause you to incur direct costs (the fees that are often taken directly out of your account) and indirect costs (the money you paid in fees that can no longer be used to generate returns). Common fees include:
Depending on the types of accounts you have and the investments you select, these fees can really add up. The first step is to figure out what you’re spending on fees. Your brokerage statement will indicate how much you’re paying to execute a stock trade, for example, and your fund’s prospectus (or financial news websites) will show expense-ratio information. Armed with this knowledge you can shop for alternative investments (such as a comparable lower-fee mutual fund) or switch to a broker that offers reduced transaction costs (many brokers, for example, offer commission-free ETF trading on select groups of funds).
To illustrate the difference that a small change in expense ratio can make over the course of an investment, consider the following (hypothetical) table:
Source: Investopedia estimates
As the table shows, if you invest in a fund with a 2.5% expense ratio, your investment would be worth $46,022 after 20 years, assuming a 10% annualized return. At the other end of the spectrum, your investment would be worth $61,159 if the fund had a lower, 0.5% expense ratio – an increase of more than $15,000 over the 2.5% fund’s return.
“I don’t know what to do” is a common excuse for postponing retirement planning. Like ignorantia juris non excusat (loosely translated as “ignorance of the law is no excuse”), lack of knowledge about investing is not a convincing excuse for failing to plan and invest for retirement.
There are plenty of ways to receive a basic, intermediate or even advanced education in retirement planning to fit every budget. Even a little time spent goes a long way, whether through your own research or with the help of a qualified investment advisor, financial planner, certified public accountant or other professional. You’re planning for your future well-being, and “I didn’t know what to do” won’t pay the bills when you’re 65 or 70.
You can improve your chances of enjoying a comfortable future if you make the effort to learn about your investing choices, start planning early, keep your emotions in check and find help when you need it. While these steps may seem overly simple, a lack of action can have huge consequences for your financial future. Stay informed and engaged in your retirement planning now to reap the benefits of a well-invested retirement plan later.