“If I had only been taught this stuff when I was young.”
I hear it often. We use the ignorance of the past to serve as our excuse for inaction today. As a young adult just entering the workforce, you likely thought the idea of retirement some 40+ years into the future was too distant to worry about. 20 years later, you started to learn that your retirement fund would have been rounding the upward curve on the compounding interest track had you gotten aboard the investment train earlier. Now you live in a beautiful 4 bedroom mortgage with two vehicle payments in the driveway, the youngest in braces, and no money saved for your 1.86 (U.S. average) children to attend college on. You now think, “How on earth can I possibly afford to put money aside for retirement now?”
The first step is to decide that NOW is the time to get started. You may have missed the previous trains, but another one is ready to leave the station right now. You just have to get onboard.
Effective financial preparation steps don’t have to be complicated. Professor Harold Pollack, a professor at the University of Chicago School of Social Service Administration, was able to offer his financial advice on an index card.
My reflections on Professor Pollack’s advice:
1. Max your 401(k) or equivalent employee contribution.
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Contributing to your employer’s 401(k) program, especially if they offer a employer match, is a key strategy for retirement planning.
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Some best-selling finance personalities might recommend only doing this once you have paid off all debt, excluding your home mortgage. I, along with most others, recommend contributing at least the amount needed to receive your employer’s maximum contribution. This strategy primes the investment pump and ensures you don’t forfeit a benefit your employer has granted you. Once your consumer debt with high interest rates are satisfied, and you are contributing the max amount to your IRA (discussed later), steadily increase your 401(k) contribution until your overall retirement contributions meet a minimum of 20% of your income (see item 4). The more you can exceed the 20% mark, the (1) greater you’ll have in your retirement years or (2) the younger you’ll be able to retire and sustain your lifestyle from your investment savings.
2. Buy inexpensive, well-diversified mutual funds such as Vanguard Target 20xx funds.
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You can open an investment account, to include an Individual Retirement Account (IRA), from low-cost brokerage companies like Vanguard, Fidelity and Charles Schwab from their websites. Once you’ve created an account and designated the type of account (ie. Roth IRA) and the type of fund (ie. Target 2035 Fund – the approximate year you would likely retire and begin withdrawing funds to cover living expenses), you can connect your bank account to begin contributing. You can manually trigger these transactions, or setup a recurring transaction to automatically make the contribution for you on a weekly, bi-weekly, or monthly basis – whatever best works with your income schedule.
3. Never buy or sell an individual security. The person on the other side of the table knows more than you do about this stuff.
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Buying stocks in specific companies can be exciting and a good excuse for delving into the details of a company that make a product you enjoy. However, this is not a good retirement strategy. Any money you invest in this manner should be money that you can afford to lose. For your serious retirement contributions, stick with diversified mutual funds, such as the many index funds offered by the aforementioned low-cost providers.
4. Save 20% of your money.
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I know…this is the “easier said than done” part. For the vast majority of us, this can only be accomplished through something we hate to consider: sacrifice
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Furthermore, let’s define what it means to “save” money. In this context, we are talking about saving 20% of your income to apply towards retirement contributions. Setting aside money for a vehicle purchase, house downpayment, or upcoming vacation would not qualify as saving money since you are simply accumulating money now for a near-future spend.
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You may look at your income and bills and think – I can’t do 20%, so I won’t do any. Start where you can. Maybe that’s 5%. Then really start scrutinizing your expenses. Ruthlessly cut out things like subscriptions, restaurants, and other frivolous items as you build it up to 6%, then 7%, then 10%, etc. 15-20% is the ideal range that most advisors recommend you strive to achieve.
5. Pay your credit card balance in full every month.
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The credit cards debate is fierce. Again, some best-selling finance personalities recommend against using credit cards under any circumstances. The logic is difficult to argue because the vast majority of Americans are spending money they don’t have, mainly to buy things they don’t need (let’s complete the saying: to impress people they don’t like). If you carry an outstanding balance each month and, as a result, pay interest for using the credit card(s), then you must stop using them and develop a strategy for paying them off as soon as possible! This is where we start seeing conflict with items 1 and 4 and need to consider the order we tackle these items. Contribute into your 401(k) the amount necessary to receive your employer’s maximum matching contribution, and then apply any and all additional funds towards your credit card balances (assuming you have interest rates in the 18-25% range) before item 4 can make financial sense. 0% credit card offers are usually accompanied by transfer fees, so some discussion and analysis of your balances would need to occur to see if progress toward item 4 could occur while a credit card pay-off strategy is also being executed.
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On the other hand, if you treat your credit cards like debit cards and reserve the money you would have paid for the item in order to pay the credit card statement when it arrives, the cash back and travel rewards offered by some credit card institutions could provide additional financial benefits to the tune of $700-$1,000 per year based on average spending of $3,000-$4,000 per month on things you would have paid using cash, check, or debit card. Within the settings of your credit card account, you will have the automatic payment option to “pay full amount each month on due date”. If you cannot confidently opt-in to the setting, you should not use credit cards for your purchases.
6. Maximize tax-advantaged savings vehicles like Roth, SEP and 529 accounts.
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These are simply different account types, like discussed in item 2.
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A Roth account offers special tax benefits. Specifically, instead of your contributions being made ‘pre-tax’, they are made ‘post-tax’. The amount you contribute does not reduce your current year taxable income, as a traditional IRA and/or traditional 401(k) contribution would. The benefit is that your investment grows over the years and that growth is not taxed at the time you withdraw the money after age 59 1/2. Which is better, pre-tax or post-tax? It depends on your situation and your behaviors. Let’s say you currently have an effective tax rate of 20% and decide to invest $100 per week. If you feel your tax rate will INCREASE during your retirement years, you might decide to utilize the Roth option. If you feel your tax rate will DECREASE during your retirement years, you might decide to utilize the traditional option. Keep in mind, to experience a similar growth-to-tax benefit, you should increase the contribution of a traditional account from $100 to $120 in order to realize the tax benefit of the pre-tax investment strategy. If you don’t invest the $20 tax amount you saved in the traditional option, the Roth option will likely generate the greatest long-term benefit. The maximum each individual can contribute to their own account is $6,000 per year, or $7,000 per year after the person turns 50 years old.
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A SEP (Simplified Employee Pension) IRA is a variation of the Individual Retirement Account used in the United States. SEP IRAs can be used by business owners to provide retirement benefits for themselves and their employees.
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529 accounts are investment vehicles that must be used to pay for education costs and provide certain tax advantages. 529 accounts are managed by individual states and the tax advantages vary depending on which state manages the fund you decide to contribute into. You don’t have to be a resident of the state to contribute into a state’s 529 account.
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Another investment option for many is a Health Savings Account (HSA). If your healthcare plan is considered a “high deductible plan”, you could qualify to invest money into an HSA to help save for your future healthcare costs. Money is contributed pre-tax, grows while invested, and can be withdrawn tax-free for healthcare related expenses. Currently, there are no time limitations on when the expense was incurred versus when you can withdraw the funds to cover the expense. So you could save your healthcare related expense information for 30 years, allowing the funds to grow by means of compounding interest, and withdraw funds during retirement without a tax consequence. Just ensure your document management system can sustain a long-term incubation. Also, you would obviously need to have the money to cashflow the expenses at the time the payment must be made in order for the investment to remain in the fund to grow.
7. Pay attention to fees. Avoid actively managed funds.
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It is often difficult to see what fees you are being charged when working with fund managers. The common rate is a 1% commission. The fund may also charge a fee, maybe another 1%. Doesn’t sound like much, does it? An explanation can be found on Vanguard’s website that provides details on the impact that 2% in fees can have on your investment. The graphic provides a quick view of the potential impact the fees would have on a $100,000 investment earning 7% over a 25 year period.
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This impact is assuming the managed fund returns the same rate as a low-cost fund that may only carry a fee that is a small fraction of a percent (eg. 0.04%). Some funds do out-perform market index funds from year-to-year, but over a long-term investment period, only a very small number of fund managers are able to generate greater returns than the market index funds.
8. Make financial advisors commit to the fiduciary standard.
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This means the person you are working with agrees to help you make decision that are in your, and only your, best interest. It is difficult to believe that someone that is paid to represent the products of an employer and only recommends the products of that employer can be a true fiduciary. In these cases, the best case is that they are helping you make decisions on which of their products is in your best interest. Undoubtedly some are also influenced by upper management regarding what products are best for the company or produce the greatest commission, but we hope this only represents a small minority of the financial professionals. In any case, it is advisable to with an advisor that is in a position to act independently for your best interest and has been registered with the SEC as a sworn fiduciary. More information on fiduciaries can be found on this U.S. News and World Report article.
9. Promote social insurance programs to help people when things go wrong.
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Be generous when possible. Give some of your time and/or money to a church that helps those in need, look for charities that provide assistance or promote causes you believe in, be a good neighbor. Be willing and happy to give from your abundance, you never know when you might be in need of a little help.
You don’t need to pay a stockbroker, investing agent, or Certified Financial Planner (CFP) to get on the right track. You might just need to talk with someone that has made good decisions in the past and can help you make some decisions now. Someone you trust that can serve as a coach.
There are more tactics that can be employed as you get settled into your seat on the train. This train seems slow, but if it stays on track and is kept properly fueled, you’ll reach your destination. We’ll discuss more tactics, and expound upon some of Professor Pollack’s, in future posts.
