Friday, October 24, 2014

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4 simple rules for retirement saving

Adam Baumgartner

Retirement planning is a topic that fills many people with dread. Not just because saving is difficult, but because advice on how to do it well is complex, confusing, and often contradictory.

Vox is here to help. While saving for retirement seems complicated, there are four simple rules that — if followed, will get you on the path to a comfortable retirement:

  • Save 12 to 15 percent of your income each year beginning in your 20s. If you're over 30 and haven't started saving yet, begin as soon as possible. The calculator below will help you to estimate how much you need to save.
  • Diversify. Invest in mutual funds that give you exposure to a wide variety of stocks and bonds, both in the US and overseas.
  • Take a long-term perspective. Younger investors should invest mostly in stocks. Resist the urge to panic sell when the market falls. As you get older, gradually shift your investments into bonds.
  • Don't let mutual fund companies rip you off with high fees. Choose the most affordable mutual funds you can find, and don't be fooled by funds that claim they can beat the market. For novice investors, a Vanguard Target Retirement fund is a good option, though not all employers offer it in their 401(k) plans.
That's it. If you follow these four rules, you have a high probability of enjoying a comfortable retirement. Read on for more details.

Use this calculator to figure out how much to save

How much should you be saving? That depends on a number of factors, including your age, income, and marital status. Fill out the form below and we'll give you a personalized estimate.

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This calculator assumes that you'll be able to withdraw between 4.7 percent and 5.5 percent (depending on your retirement year) of your nest egg each year for the rest of your life. That's the approximate rate you can get from a life annuity, an insurance product that pays a fixed (inflation-adjusted) amount each month until you die.

The calculator assumes you'll need 80 percent of your pre-retirement income to live comfortably. It assumes that you'll receive annual raises of 3 percent (plus cost of living) until age 50, and that after that you'll only cost-of-living increases. It assumes an average stock market returns (after inflation) of 4 percent. (These assumptions can all be changed by clicking "Show advanced options.")

It takes into account your projected Social Security benefit. Social Security has a progressive benefit formula, meaning that wealthier taxpayers have a smaller fraction of their income replaced in retirement. So the wealthier you are, the more you'll need to save to replace your pre-retirement income.

To protect your privacy, all calculations are done inside your browser. Information you enter into this form is never sent to Vox's servers.

If your employer offers matching funds, always take them

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(401(K) 2012)

Many employers offer to match the first 1 to 3 percent percent of salary an employee saves. If your employer offers an option like that, you should always take it. That's hundreds of dollars in free cash you get just for doing something you should be doing anyway.

Don't panic when the stock market drops

Stock_growth

Someone who invested $10,000 in the S&P 500 on January 1, 1989, and re-invested dividends, would have had almost $60,000 (in 1989 dollars) on January 1, 2014. Notice that even after stock market crashes in 2001-3 and 2008-9, our hypothetical investor still had more than twice his initial investment.

A fundamental principle of investing is that there's a trade-off between risk and reward. A savings account is a much safer place to put your money than the stock market in the short run, but staying out of the stock market is likely to leave you poorer in the long run.

In 2008 the S&P 500 — an index of the the stocks of the 500 largest companies in America — lost more than a third of its value. The experience soured many people on the whole concept of investing in the stock market. Yet it's important to look at things from a long-term perspective. Anyone who started investing in the 1970s, 1980s, or early 1990s was still ahead after the 2008 crash. And anyone who held onto their stocks through the 2008 stock market plunge enjoyed big gains over the next five years. By the end of 2013, the market had erased all of its 2008 losses and then some.

Things look even better if we look further back in history. Since the modern stock market emerged in the late 19th century, there has never been a 20-year period when average stock market returns were negative. Since 1914, the average return on the 500 largest US stocks — after adjusting for inflation — has been 6.7 percent. Coincidentally, the S&P 500 earned the same 6.7 percent real returns over the last 20 years, despite the stock market crashes in 2001 and 2008.

So in the long run, stocks are likely to provide higher returns than less volatile investments. And if you're under 45, you're young enough that you can afford to take a long-term view. If the stock market crashes next month, you'll still have 20 years for the value of your portfolio to rebound. The odds are high that you'll come out ahead.

But it's essential not to panic when the stock market does fall. When the stock market crashed in 2008, a lot of people were tempted to sell. But that proved to be a big mistake. People who held onto their stocks wound up way ahead of people who sold in 2008 or 2009.

Diversification lowers risk

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(Al Bello/Getty Images)

OK, so you should buy some stocks. Which ones? The answer is surprisingly simple: buy all of them.

Individual stocks can be extremely volatile. There's always a risk that you'll pick the next Enron and be left with nothing. But there's more safety in numbers. On any given day, one stock might crash but others will be rising. So a basket of many stocks is less volatile than any single stock by itself.

This is known as diversification. And it applies beyond the American stock market. In addition to buying domestic stocks, you should also buy some foreign stocks. And you should buy bonds — the debt of corporations and governments.

Bonds are less volatile than stocks, and the value of stocks and bonds often move in opposite directions. So a mixed portfolio of stocks and bonds is a lot less volatile than an all-stock portfolio.

It would be a huge hassle to buy thousands of stocks one at a time. But fortunately, mutual fund companies have made the process relatively painless. Mutual fund companies offer funds that allow you to buy a small share of thousands of different stocks or bonds — just by buying into one fund.

Don't try to beat the market

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Pay no attention to stock tips from finance gurus like CNBC's Jim Cramer. (Tulane)

Open a personal finance magazine and you'll see articles touting the latest hot stock tips. You'll also see ads from mutual fund companies touting their above-average investment returns. The evidence suggests that this is all kind of a scam.

A lot of people on Wall Street make a lot of money by convincing ordinary investors that they can provide better-than-average returns. But the reality is that beating the market is really difficult. Most people who promise to do it don't deliver.

In the 1960s, academic researchers began to show that, on average, active mutual fund managers don't produce returns higher than the market average. This research led to the rise of a new type of mutual fund known as an index fund. Rather than trying to beat the market, these passively-managed funds simply try to match the returns of a stock index such as the S&P 500. Index funds allow investors earn the average market return, with as few expenses as possible.

A half-century later, studies are still finding that passively-managed funds consistently over-perform actively-managed ones. It's hard to outperform the market, but it's easy to waste clients' money trying. The higher expenses of actively-managed funds wind up coming out of the pocket of ordinary investors.

So when choosing mutual funds, your most important criteria should be keeping costs down. Every mutual fund publishes an "expense ratio," which is the percentage of your investment that will get eaten up by management expenses each year. Whenever you have a choice between two similar funds, you should pick the one with lower expenses.

Pick the fund with the lowest fees and expenses

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(Stefan Irvine/LightRocket via Getty Images)

Which fund should you buy? The best option for a novice investor is a Vanguard Target Retirement fund. You pick the year you want to retire (for example, if you're in your late 20s you'd pick the Target Retirement 2050 plan), and Vanguard automatically allocates your savings to a mix of stocks and bonds that's appropriate for your expected retirement date. It has a modest 0.18 percent expense ratio, meaning that consumers pay just $180 for every $100,000 invested.

Why Vanguard? Other mutual fund companies offer similar target-retirement products, but the other options I can find are all a lot more expensive. For example, Fidelity's Freedom 2050 fund and T. Rowe Price's Retirement 2050 funds both have expense ratios of 0.78 percent. That means you lose $780 per year for every $100,000 invested. That's a terrible deal.

Unfortunately, many employers don't offer Vanguard as an option in their 401(k) plans. If your employer is one of them, you'll need to do a bit of extra work. Instead of buying a single target retirement fund, you'll want to invest in funds from the three categories I mentioned before: domestic stocks, international stocks, and bonds.

For each category, you'll want to choose the broadest fund with the lowest expense ratio. For example, Fidelity's Spartan Total Market fund, with an expense ratio as low as 0.05 percent, is a good choice for domestic stocks. It invests in more than 3000 US stocks. Fidelity also has a Spartan International fund (0.12 percent expense ratio) for international stocks and a Spartan U.S. Bond fund (0.10 percent expense ratio) for bonds.

Mutual_fund_expenses

Unfortunately, many mutual fund companies don't offer low-cost index funds. The table above shows some of the largest mutual fund companies in America, along with their lowest-cost fund in the three asset categories I mentioned before. In the right column is a weighted average of these expenses, assuming a portfolio of 60 percent domestic stocks, 20 percent international stocks, and 20 percent bonds.

As you can see, only Fidelity and Vanguard offer truly low-cost index funds. These companies let you construct a diversified portfolio with an expense ratio as low as 0.07 percent. Most competitors charge 4 to 10 times as much.

While a fraction of a percentage point might not seem like a big difference, these expenses can add up to thousands of dollars in lost returns over the course of a typical worker's career. So if your employer only offers high-cost mutual funds in your 401(k) plan, you might want to ask your HR department to add lower-cost options from Vanguard or Fidelity.

If that doesn't work, you might want to consider opting out of your employer's 401(k) plan altogether and invest in an IRA (discussed below) instead. That would allow you to take advantage of low-cost index funds or — even better — Vanguard's low-cost target retirement funds. But the rules about when you can do that are complicated and beyond the scope of this article.

Keep your portfolio balanced

If you don't have a target retirement fund, then you'll need to decide how much money to allocate to different types of funds. Here are some guidelines:

Portfolio

If you're under 40, you should have most of your money in high-risk, high-reward stocks (including both domestic and foreign companies), and only a small share in safe, low-return bonds. As you get older, you'll want to gradually shift to more bonds. The majority of your savings should be in bonds by the time you reach your 60s.

The exact ratio of stocks to bonds depends on how much risk you feel comfortable taking. If seeing the stock market plunge gives you heartburn, you might want to allocate a larger share of your portfolio to bonds. If you're willing to take a bit more risk in pursuit of higher returns, you should have a portfolio that's weighted more toward stocks. Of course, the closer you are to retirement the more conservative you'll want to be with your money.

In some years, stocks will perform dramatically better than bonds, pushing the ratio of stocks to bonds upwards. In other years, stock prices will fall, leading to a portfolio with bonds over-represented. When this happens, you should sell some of the over-represented assets and buy more of the under-represented ones, bringing your portfolio back into balance.

This will mean selling assets that have performed well and buying assets that perform poorly. That might seem counterintuitive, but think about it this way: Selling stocks as they rise helps to lock in some of the profits even if prices subsequently crash. And buying stocks when they're cheap gives you more upside if they subsequently rise in value.

Target retirement funds handle this chore for you automatically. If you're managing your portfolio yourself, then you'll want to log in every 6 months to make sure the ratio of stocks to bonds (and of domestic stocks to international ones) stays on target.

Don't fall behind on savings just because you don't have a 401(k) plan at work

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(Education Images/UIG via Getty Images)

If you have a job that offers a 401(k) plan, this is a convenient way to save for retirement. The money is automatically deducted from your paycheck, helping you to stay on track. And you don't have to pay taxes on money in your 401(k) until you withdraw it in retirement.

But if you don't have a 401(k) at work — or you don't have a full-time job at all — you should still be saving for retirement. Congress has created a separate system for people in this situation. Known as an Individual Retirement Account, it provides tax benefits similar to those of a 401(k) for those who don't have an employer-sponsored retirement plan.

There are two types of IRAs. A traditional IRA works a lot like a 401(k) plan. Contributions can be deducted from your taxes and taxes are deferred on earnings. But as with a 401(k), you have to pay a hefty penalty if you take the money out before you reach retirement age. And you also pay taxes on money you withdraw from the IRA during retirement.

A Roth IRA works the other way around: you pay taxes when you put money in, but earnings and withdrawals are tax-free once you retire. You can also withdraw your contributions (but not earnings) to a Roth IRA at any time without paying a penalty.

Which one you should pick depends on whether you expect your tax rate in retirement to be higher or lower than the tax rate you're paying now. When you're just starting your career, you might be in a lower tax bracket than you expect to be in later in life. In that case, a Roth IRA is a good choice. On the other hand, if you expect to be in a lower tax bracket in retirement, then a traditional IRA might make more sense.

There are also income-based limits on contributing to IRAs, so if you make more than $114,000 you'll want to double-check your eligibility.

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