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Figuring out
how to save for retirement is hard. Attempting to wrap your mind around the
many technical terms, determining how changes in the tax laws affect you,
and staying current with the stock market – not to mention researching
the mind-boggling array of choices for investments – can be downright
intimidating. Before you start stashing money under your mattress, however,
hear this.
Financial experts agree that, fundamentally, planning for retirement is really a systematic process. It can be simplified by a step-by-step custom tailoring of your retirement portfolio. The following six steps should help you approach retirement planning with less anxiety.
Step 1: Set
your goals and determine your income requirements
To begin, look
into your crystal ball and imagine what the next thirty-plus years will bring.
What are your life goals? How do you see your life changing as you age? If
you are like most Americans, your early retirement years will be active, probably
filled with travel, hobbies and maybe even a part-time job. The later years
will inevitably bring a slower-paced routine – and, eventually, the need
for help with daily living.
Next, estimate
how much you must save to give you the income you believe is necessary for
you to retire in comfort. Joe Vizzini, CPA, CFP of Financial Horizons, says
that the current rule-of-thumb suggests that retirees will need an income
equaling about 75 percent of their pre-retirement take-home pay. Don’t
forget to factor in inflation, however, which has historically been about
5.3 percent per year. Look at what it costs today to live the retirement lifestyle
you dream of, and then estimate what it will cost when you retire. Got sticker
shock? It is important to keep in mind that your return must outpace the rate
of inflation for your purchasing power to grow in real terms.
So, exactly how much of your hard-earned cash will you have to stash away each year to achieve your retirement goals? The best way to solve this math problem is two-fold: going forward and working backward. First, jot down how much you can reasonably afford to save now, then work backwards from the year that you anticipate retiring to see how much you will actually need. If math has never been your forte, don’t panic. Online calculators will do the calculating for you. Try www.hibernia.com/investment_services or www.400.fidelity.com for more information – and to use their calculators.
Step 2: Determine
your risk tolerance level
Now you are ready
to determine your personal comfort level, or how much risk you are willing
and able to tolerate. The answer depends somewhat on your personality, but
is largely a factor of your age. In other words, do you have the luxury of
time, or are you playing catch up?
According to
Margie Benjamin, financial consultant with Hibernia Investments LLC, your
time frame is very important. The younger you are, the more aggressive you
can be with your portfolio. As you age and get closer to retirement, you should
look at investments that are more conservative.
Each individual must determine how much risk is tolerable. A U.S. Treasury bond that guarantees six percent interest might be considered a sure thing, while a stock might have the potential for a much higher return, but runs the risk of a much lower one. If you have the luxury of time, the bright side of being more aggressive is that the higher the risk, the faster your money may grow over the long haul. The downside is that there is no guarantee that your stock or mutual fund won’t drop in price. This could be devastating if you don’t have time to rebuild. Once you know how much risk you can stand, you will be able to manage your money more effectively.
Step 3: Choose
a financial advisor
It may take more
than a generous dose of self-discipline to withstand spending your current
income now, whether on that fabulous vacation to Fiji or on something more
mundane, like paying off your seemingly insurmountable Visa bill. A professional
financial advisor may be needed to help you stay focused on investing a portion
of your paycheck in the specific retirement package that is right for you.
Very few working
Americans actually have the time required to delve into the vast cornucopia
of available investments. If you can’t do the research yourself, your
best resource may be a financial advisor. An investment advisor and/or other
professional, such as a financial planner, stockbroker, or an accountant,
can offer individual guidance, expertise and access to a wealth of knowledge
about almost any type of investment or retirement planning concern.
To find the right advisor, ask for recommendations from trusted sources, or contact the Financial Planning Association for a list of qualified people in your area. (Be sure to check references.)
Step 4: Choose
your investments wisely
After you make
the difficult decision of how much to save, the next big question is where
to invest your savings. Lee Spence, senior vice president and senior trust
officer with Parish National Bank, offers this advice, “Select your proper
asset allocation and diversify your investments.”
You’ve heard
it a thousand times: diversify. What does it mean? The main challenge that
you face is earning the desired level of return while managing the risk involved.
Diversification, or spreading your money out over a variety of investments,
makes you less vulnerable if one or two sour.
According to
Spence, who has been in the financial planning business for more than thirty
years, an old adage rings especially true when investing for the long term:
“Don’t put all of your eggs in one basket.” To keep a diverse
retirement portfolio, experts agree that you should spread your investments
among different classes of assets, a balancing act known as asset allocation.
Your advisor can help you determine how your assets should be divided among
stocks, bonds, and/or other investments.
The goal is to
choose funds that have the potential to meet realistic expectations. At the
base of most plans are tax-deferred savings plans, like 401(k)s, which, if
left alone until retirement, grow faster than if you were required to pay
yearly taxes on the interest and capital gains. Unless you make early withdrawals
that may incur penalties, generally you do not pay the deferred taxes until
you begin withdrawing money from the 401(k), sometime between ages 591/2 and
70.
While your 401(k)
is typically the foundation of your retirement plan, experts recommend saving
at least 10 to 15 percent of your income each year before you retire –
or even more as you age – if you want to enjoy the same standard of living
after retirement. There are other tax-deferred accounts, such as traditional
Individual Retirement Accounts (IRAs), that allow the earnings on your investments
to grow, tax-deferred, until you begin making withdrawals at a certain age.
By maximizing your net returns, you will have more money to continue investing
and growing. Keep in mind, however, that, with few exceptions, withdrawals
are taxed as ordinary income and may be subject to a federal 10 percent penalty
prior to age 591/2.
Beginning this
year, workers under age 50 can contribute up to $3,000 to an IRA, according
to Greg McMahon, Fidelity Homestead vice president. This is up from the previous
annual limit of $2,000; those age 50 and older can contribute as much as $3,500.
The good news only gets better, as these contribution limits will continue
to increase over the next few years. For example, in 2005 through 2007, the
contribution limit for workers under 50 will increase to $4,000 a year, while
workers 50 and up will see increases to $4,500 in 2005, and as much as $5,000
in 2006 and 2007.
If you look solely
at returns over time, stocks have historically outperformed all other forms
of investment. While their prices can swing from extreme highs to extreme
lows year-to-year, over longer time frames, like five and ten years, average
returns on stocks have generally been more stable and growth more reliable.
However, compared with safer bets, such as long-term bonds and cash equivalents,
including CDs and T-bills, stocks can be subject to more volatility. They
bring with them the risk that, in the end, an investment may lose some or
all of its value, or may not make any significant gains. Any reputable financial
advisor will stress that there is never a guarantee that future results will
be consistent with past performance.
By balancing the asset classes in your portfolio, you will be building a cushion to protect your investments from the inevitable downturns in any one specific asset class at any given time. As recent headlines have indicated, most experts advise not having more than 20 to 25 percent of your 401(k) invested in your company’s stock. That way, if the company goes down the tubes, you don’t risk the threat of losing your job and your retirement savings in one fell swoop!
Step 5: Pay
yourself first
Your financial
advisor will most likely counsel you to “pay yourself first,” which
means setting up an automatic draft from your bank account or regular deductions
from your paycheck so that a portion of your income goes directly into your
retirement funds. This way, you are less likely to feel the impact of setting
aside savings, as you will never really have the money in your hands to tempt
you to spend it now.
“Maxing-out
your 401(k)” is a fancy way of saying you should put as much as the law
allows into your plan, especially if your company has a matching policy, which
essentially gives you free money. Most experts will tell you that if you have
an emergency cushion of at least three months’ living expenses, not including
your 401(k), you should be able to contribute the maximum to your employer’s
plan. Currently, 401(k) plan participants can contribute up to $11,000; new
tax laws, however, will allow contributions to increase by $1,000 each year,
gradually reaching a maximum limit of $15,000 by 2006.
Although at times
you may be tempted to give yourself a loan, you should resist treating your
401(k) like a Visa card. 401(k) loans typically must be repaid within 30 to
60 days after you leave a company for any reason. If the unexpected happens
and you lose your job, you would owe federal and any applicable state income
taxes on the balance, plus a possible 10 percent early withdrawal penalty,
if you were not able to repay the loan in full.
What happens to your 401(k) when you change jobs? Generally, it stays with your former company until you instruct them to move it. A financial advisor can help transfer the savings in your 401(k) account into an IRA rollover, allowing your money to continue growing tax-deferred.
Step 6: Revisit
your portfolio often
Finally, because
goals can change over a lifetime, your investments should be able to change,
too. Think of your retirement portfolio as a plan-in-progress, one that needs
to be rewritten periodically. An advisor can help you reevaluate your asset
allocation at different points in your life, and can make recommendations
for adjustments.
With a little luck, a lot of thoughtful planning, and some combination of
a 401(k), an IRA or two, Social Security benefits and personal savings, you
can be optimistic about building a nest egg and funding your retirement goals.
Copyright © 2002 L&M Publishing, L.L.C. All rights reserved.
