How to save for retirement

The other day, I received this message:

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I’m a firm believer that educating yourself on the basics of investing, personal finance, and retirement saving is one of the most important things you can do in your twenties. A working knowledge of this stuff can have a big pay-off in the form of your standard of living, your financial freedom, and your general sanity. Unfortunately, it’s not taught in school. It’s on us to learn it and apply it.

OK – to start, there are few main investment vehicles you can use to save for retirement: a 401(k), a Roth 401(k), a normal IRA, and a Roth IRA. All of these are useful because they grow your investments tax-free, meaning you don’t pay taxes on any earnings or dividends.

You may know all of this already, but in case you don’t:

A 401(k) is a retirement savings plan that is sponsored by an employer. It lets you save and invest a piece of your paycheck before taxes are taken out. A lot of times, your employer will match a certain portion of your 401(k) contributions (3 or 4%, sometimes more). You should, at a minimum, invest the same as your employer match. This is what we in the business call ‘free money.’

Once you sign up for your company’s 401(k) plan, you’ll have a list of stocks or mutual funds to pick from. Each company’s plan is different – some have 10 choices, some have 100. The funds you choose are entirely up to you (you can put everything in one fund, or in five different funds, whatever you want), but there are certain things to be wary of (namely, fees) that we’ll tackle later.

The money in a 401(k) sits there for a very long time, and it will grow with each paycheck and with each rise in the market. Sometimes it will fall, like in 2008 when the stock market halved. But there’s no need to worry about the daily, or even yearly, moves in the market, because you can’t touch the money* in your 401(k) until you’re 59 1/2 years old. And, thankfully, 40-year market returns are pretty great (the market has risen 2,100% since 1976).

*Well, this isn’t entirely true. You are allowed to withdraw funds from your 401(k) early (usually in an emergency), but you have to pay a 10% penalty, in addition to taxes.

A 401(k) offers lots of great benefits (employer match, tax-free growth), but there’s a limit of how much you can put into it each year. For 2016, that’s $18,000. If, for some reason, you accidentally contribute more than $18,000, you have until tax time (April) to withdraw the excess and set everything straight (or else you pay a penalty).

Some employers also offer a Roth 401(k). It’s very similar a normal 401(k) – a small portion of your paycheck gets set aside for retirement, but it’s taken out post-tax instead of pre-tax. So you pay tax on it now instead of later.

A traditional IRA is an individual retirement account that you have outside of work. It’s similar to a 401(k) in that you contribute your money on a pre-tax basis, so you don’t pay tax on it until you withdraw funds down the road. Most of the major banks and financial institutions offer some sort of IRA.

Roth IRA is like an IRA, but your contributions are post-tax instead of pre-tax. In other words, you can contribute your ‘take-home pay’ to a Roth IRA, and since you’ve already paid tax on it, you can withdraw funds tax-free. The two things to be aware of with a Roth IRA – the maximum you can contribute is $5,500 per year, and you can’t contribute if you make more than $132,000.

In summary:

401(k) Roth 401(k) IRA Roth IRA
Eligiblity if your employer offers it if your employer offers it anyone if you make less than $132,000
Max annual contribution $18,000  $18,000 $5,500 $5,500
Are deposits taxed? no – your deposits come directly from your paycheck, pre-tax yes – your deposits come directly from your paycheck, post-tax yes, but they’re tax-deductible if you don’t have a 401(k) yes
Are withdrawals taxed? yes no yes no
When can you withdraw? age 59.5, required by 70.5 age 59.5, required by 70.5 age 59.5 age 59.5, required by 70.5
Early withdrawal? minimum 10% penalty  ok, but you have to pay taxes on the earnings ok for high medical bills, $10K towards a first home, higher education, disability, or death; otherwise, 10% penalty ok for high medical bills, $10K towards a first home, higher education, disability, or death; otherwise, 10% penalty

Personally, I have a 401(k) through my job and a Roth IRA (with Fidelity) on the side.

Here are some general best practices for saving for retirement:

Start now. In the world of saving and investing, the most precious resource you have is not smarts or analysis or research. It’s time. The power of compound interest over a thirty or forty year period is amazing.

This is a real quote from Albert frikkin’ Einstein:

Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.

Here’s the example I always use at parties. If I…

Save $10,000 a year from age 22 to 30, and then I stop and never save another dime for retirement.

And you…

Save $10,000 a year from age 31 to 60…

Guess who ends up with more money at age 60? Me! Even though I saved $220,000 less than you did.

No one ever seems to believe me, so then I load up Microsoft Excel, input the numbers, show them the data, grab ’em by the shoulders and shake ’em, and stare intimately into their eyes until they finally start to understand.

This is something that isn’t taught, and unfortunately a lot of people don’t fully appreciate the power of time until it’s far too late. So what I would say is: start now, contribute what you can to your retirement accounts (start at 5%, and go from there), and your future self will be quite happy. He or she exists, and you will soon become that person. Unless something terrible happens. Don’t die.

Do not invest in individual stocks. This is just my own personal philosophy, but I don’t think you should invest in individual stocks in your retirement accounts. Why? Because you’re not touching that money for forty years, bub, and a lot of companies aren’t going to be around in forty years. Instead, I would recommend a mutual fund that closely tracks the broad US stock market. A mutual fund, by the way, is just a collection of stocks (and/or bonds), so you hedge yourself against the failure of a single company. In other words, don’t put all of your eggs in one basket.

That’s not to say that you shouldn’t invest in individual stocks. By all means, go crazy! Just don’t do it in your retirement accounts, please. Also, stock-picking is a tricky thing. Most stock-pickers don’t beat the market. The one exception is my friend Eddy Elfenbein, who routinely beats the market, and spoke with me about it two years ago.

Watch out for fees. OK, great, you realize that investing is important and you’re committed to setting aside $10,000 every year until you retire in forty years. On average, let’s say your investments increase by 8% annually over the next forty years, which is actually lower than the long-term average. You pay, on average, a 0.25% fee on your investments. In forty years, you’ll have $2,613,971.03.

Now let’s say you invest that same $10,000, over the same forty year period, in the same kind of funds, so on average you’re still getting 8% per year. But the funds you chose charge 1.25%, not 0.25%. In forty years, you’ll have $1,998,500.80.

In other words, a 1% higher fee will eat 25% of your total investment value.

It doesn’t sound right, but I’ve done the math and the people who are selling these things hope you haven’t. Fees are absolutely debilitating over the life of your investments, which is why the majority of your investments should be in low-cost funds, ideally 0.50% or less.* Companies justify their higher fees by saying they produce higher returns, but that is categorically untrue. But don’t take my word for it. Read this or this or this or this or this or this or this.

*But the fee shouldn’t be 0%. You SHOULD be paying a small fee for all of the things a mutual fund can do for you – re-balancing, tracking the market, hedging against the failures of an individual stock, creating tax advantages, and (hopefully) giving you a nice safety net when all is said and done.

Think of a mutual fund as a product.

The more expensive one’s, generally called ‘active funds’, will have lots of smart people looking at lots of data to try to maximize the performance of the fund. The idea is that you, as the consumer, will be rewarded, in the form of a superior return, for paying a higher fee. You pay more to get more.

The less expensive funds, called ‘passive funds’, will contain a bunch of stocks that mimic the direction of the Dow Jones or S&P 500 Index or perhaps another sector. Passive funds are not actively managed, and they are built for the long haul. It’s a ‘set it and forget it’ strategy. If the market does well, then great, so do you. If the market doesn’t do well, then neither do you.

Again, the problem with the first strategy is that it’s really hard to beat the market. In the last year, 90% of US equity funds failed to do so. Every now and then, a fund like Peter Lynch’s Magellan Fund will come around, which averaged a 29.2% annual return from 1977-1990 and had the best 20-year return of any mutual fund ever. But these are rare.

The real danger with fees is that they aren’t very transparent, and you’re not actively paying the fee when you withdraw your money. Fees are baked into a fund’s NAV (net average value), or the share price of the fund. So you never see exactly how much you’re paying in fees. All funds are, of course, required to disclose their fees, but they’re not required to tell you. Thankfully, things like Google and Yahoo Finance exist, so they’re pretty easy to look up.

OK, so I understand that compound interest is amazing and fees are awful, plus all of the other stuff you said. So what should I specifically invest in, smartypants? 

An example of a low-cost mutual fund that tracks the S&P 500 is the Vanguard Total Return Index (VFIAX), which recently celebrated its 40th anniversary.

The Vanguard Total Return Index is pretty boring. It tracks the broad US stock market. It has an expense ratio of 0.05%. It holds some winners and some losers – it’s not loaded with tech start-ups in Silicon Valley, or emerging markets like China or India, or whatever the hottest trend is of the day. Nope, it just trudges along, facing strong headwinds here and there like recessions and wars and inflation and panics. But the fund rewards patience. It has a cumulative total return of 6,091%, or 10.86% annually.

Not every 401(k) plan will offer Vanguard funds, but thankfully it’s far from the only low-cost mutual fund out there. There are hundreds of them now. Fidelity offers one (FSTVX) with an expense ratio of 0.045%.

Vanguard, by the way, has become the single most influential force in the asset management industry. It’s been estimated that the firm has saved investors approximately $1 trillion in unnecessary fees over the years.

Got it? Good…wait…what…oh God what else do you want?

This all sounds great, but I don’t really want my money to track the stock market, because market volatility gives me severe diarrhea and I’m worried Trump will become President and everything will go to hell.

That’s a valid concern. Some people don’t want to take on the added risk of investing their hard-earned money in the stock market. Market crashes happen every few years, and they’ll happen again.* It’s completely understandable if you’re scared of the stock market, though I’ll mention that historically, the market provides the best returns of any investment vehicle – more than real estate, more than bonds, more than CD’s, more than beanie babies, more than my baseball card collection, all of it.

*Not just because of macroeconomic events or terrorism, but because of anything. Just recently, the market dipped 20% because of ebola (remember that?). Who knows what the next 40 years will bring! I’m guessing: climate change, solar flares, super virus, alien invasion, and robots who don’t listen to directions.

If you want to avoid diarrhea, I would recommend allocating part of your retirement funds (say, 40%) to bonds or other fixed income products. You’ll take on less risk (yay!), but you’ll probably see lower returns over a long period of time (boo!). That’s how the game works.

And then as you get closer to retirement, you should start shifting more and more of your money into fixed income products. When you’re 65, a guaranteed rate of return (even if it’s lower) will be more important than the whimsies of the stock market.

IN CONCLUSION:

Start investing as early as you can.

Take advantage of your company’s 401(k) plan.

Invest in simple, low-cost mutual funds that track the broad US stock market. Or invest part of your portfolio in bonds, if you’re more risk-averse.

Watch out for fees.

Continue to make contributions, regularly, for the next four decades or so.

Enjoy your retirement!

Also, try not to lose your job.

All of this advice is very specific to someone my age – mid-twenties, out of school, working full-time. If you’re older, it’s a different story. If you’re in debt, it’s a different story. If you’re saving for your kids’ college, it’s a different story.

If you have any specific questions, or would like some further elaboration, feel free to email me or comment below.

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