Saving for retirement has a new look. No longer a concern that can wait until mid-life, putting away money for the long term starts with your first job and continues for at least four decades. Thankfully, the nest-egg building process has become simpler with innovations like target-date and exchange-traded mutual funds.
Starting early and saving unwaveringly is the only way that most people will manage to lock up financial security by age 65—and afford the life they envision for the rest of their years. That’s because traditional pensions are all but gone and Social Security looks more like a meal plan than a retirement plan. The onus of retirement income has been shifted from employers and government to individuals, and the only dependable way to lighten this burden is to address it at every life turn.
Americans are just beginning to understand this shift in responsibility—too late for many. Some 69% of workers say they won’t have a large enough nest egg to retire at age 65 and more than half plan to compensate by working longer than they’d like, according to the 2012 Transamerica Retirement Readiness survey.
Young people have been especially slow to grasp the new look of retirement saving; they mistakenly view retirement security as an issue to tackle down the road. Wells Fargo found that just 13% of Millennials (largely the children of boomers) elect to participate in a 401(k) plan. Workers under age 35 have the lowest savings rate of any group, according to the Center for Retirement Research at Boston College. The reason for this, the center found, is “deeply rooted in psychology: when an event such as retirement is far in the future, people tend to distance themselves from it.”
But many who put off saving do so in part because they are not sure how to go about it and don’t trust financial advisers to give them the best information. Saving smart throughout life isn’t as difficult as you might fear. Start with these simple guidelines:
- Pay yourself first Arrange for 10% of each paycheck to be automatically directed to a savings plan, like a 401(k) or IRA. Soon it will feel like any other debit coming out of your paycheck. Quickly, you’ll learn to live on what’s left.
- Start early Compound growth works miracles over long periods of time. At annual returns of 7%, money doubles about every 10 years. So if you start saving at age 20 and keep at it until age 70 you stand to wind up with twice as much money as if you start saving the same amount at age 30 and keep at it until age 70. The extra 10 years can turn, say, $1 million into $2 million.
- Stay with stocks The market has had some rough patches the last dozen years and it hasn’t been easy staying with stocks. But the S&P 500 has never had a negative total return over a 20-year period. This is a long-term game and stocks offer the most promise for inflation-beating returns.
- Budget for the unexpected Keep an emergency fund equal to six months of living expenses in a place you can easily access. This ensures that you won’t have to stray from your savings program or dip into long-term savings for an unexpected expense.
Once you are saving, you’ll need to invest your kitty wisely. That means different things at different points in your life. One common rule is to subtract your age from 110 to give you the percentage of your portfolio that should be in stocks with the rest being invested in bonds. It’s simplistic yet effective. If you are 50, you should have 60% in stocks and 40% in bonds; at 65, you should have 45% in stocks and 55% bonds.
This convenient rule is a nice start. But you still must figure out how to diversify and which products best get the job done. Here’s a more detailed look, by age groupings, for how to build the perfect retirement portfolio:
Ages 20 to 29
This is the 10-year window that can make all the difference. Since you haven’t saved anything yet, the most important part is to simply get started and give your money 40 or 50 years to grow. “Do what you can to get used to living on a little less now,” says Bill Allen, vice president of portfolio consulting at Schwab Private Client Investment Advisory. “It will be much harder later on.”
Make sure you are contributing enough to get the full match in your 401(k) plan. At this age and with little in the way of savings you can afford to start with an all-stock portfolio. To make certain you have a broad mix of stocks at a low cost, consider something like the U.S.-centric Vanguard Total Stock Market Index Fund or Fidelity Spartan Total Market Index Fund. A global option is the Vanguard Total World Stock index Fund.
If you are unnaturally conservative at such a tender age, go with an actively managed balanced fund that invests in both stocks and bonds. One highly regarded is Dodge & Cox Balanced. You might also start with a target-date fund, which automatically adjusts your stock-bond exposure as you age. These are available through most big fund companies.
Time is still on your side. So remain aggressive with a heavy dose of stocks. If you’ve saved more than $40,000 and want to try individual stocks go ahead, but go slowly. The vast majority of your savings should be in funds that provide broad diversification. You might also consider industry-specific ETFs, so long as you can own enough to get access to eight to 10 industries.
A smart asset allocation would be 80% stocks (45% large cap, 15% small cap, 20% international) and 20% bonds. Says Schwab’s Allen: “Most important is having a clear long-term strategic asset allocation, a savings discipline and process of rebalancing—not looking to hit the home run.”
Total market funds still make sense, as do target-date funds for folks who don’t want to think too much about their investments. That’s fine, by the way. Target-date funds are a turnkey solution that has brought millions of savers into the market with professionally managed age-appropriate asset allocations.
Target-date funds have drawbacks. Some have high fees. Look for those that charge less than .75% of assets. Target-date funds robotically move assets according to age with no consideration for market conditions. You could end up shifting out of stocks and into bonds at just the wrong moment.
But they are an increasingly popular and useful part of the landscape. Vanguard notes that 64% of all new participants in 401(k) plans put all of their contributions into a single target-date fund, and that by 2016 more than half of all participants will have all their assets in one of these funds.
As your portfolio grows it may be appropriate to add exposure to additional asset classes for further diversification. Gold, commodities, and emerging markets securities can be an effective addition and offer some protection against an inflation surge. An ETF like SPDR Gold Shares, which physically holds gold in a vault, is a simple way to add glitter; consider an ETF like iShares GSCI Commodity-Indexed Trust for broad exposure to metals, materials and agriculture. Emerging markets funds are widely available through traditional mutual funds as well as ETFs.
Some target-date funds already incorporate emerging markets and an inflation hedge. The T. Rowe Price retirement series of target date-funds, for example, include a smattering of the firm’s Real Assets Fund, which invests in stocks of companies that have significant exposure to natural resources, real estate, metals and mining, infrastructure, energy, and other commodities. These target-date funds also hold the Inflation-Focused Bond Fund, which is laden with Treasury Inflation-Protected Bonds, or TIPS.
“Our research shows that these types of real assets and inflation protected bonds should reduce overall portfolio volatility by dampening the effect of inflationary trends over the long term,” Jerome Clark, portfolio manager of the retirement funds, says in a report. Don’t go overboard. At age 45, you’d be in the 2035 target-date fund, which has just 3.6% in the Real Assets Fund and 5% in emerging markets. At this age you still want 65% to 75% of your assets in stocks.
This is when it’s time to start considering your “glide path” to retirement, beginning to tilt to high quality bonds and blue chip dividend paying stocks. Again, ETFs are a convenient vehicle. For stock dividends, consider something like the SPDR S&P Dividend fund. And remember that target-date funds do the proper tilting for you. It’s important to keep significant exposure to stocks (55%); you still have many years ahead and will need your portfolio to grow. But you don’t have so many years left that you can easily weather a dramatic hit to your savings.
Now is when you should begin to introduce short-term bond funds (start with 5% of assets) as part of your fixed-income allocation. These funds will hold up relatively well if interest rates soar and holders of long-term bonds take a hit. Small amounts of gold and commodities still make sense.
Even in retirement you should maintain a balanced and diversified portfolio that includes some stocks. Your level of stock exposure will depend on your health and risk tolerance. At the low end, you’ll want 20% in stocks and at the high end 45%. As a point of reference, recent retirees holding the Fidelity Freedom Funds target date 2010 fund had automatically glided to an allocation of 31% U.S. stocks, 14% foreign stocks, 5% commodities and 50% bonds (including TIPS and various types of short-term debt). If you are managing your investments, this might be a good time to introduce low-cost deferred fixed annuities as part of your bond allocation.
Consider a three-bucket approach. In bucket one you set aside three years of expenses. In bucket two you build a portfolio of short-term bonds with some portion maturing every year for seven years. In bucket three you hold deferred annuities, longer duration bonds, and dividend-paying stocks with the goal of letting that bucket alone for at least 10 years.
Saving for retirement doesn’t have to be complicated, which is a relief because for most folks it’s a life-long process.