11/21/06 - 2007: The Year You Get in Shape...for Retirement

By: Investor Solutions

My favorite time of year is just around the corner, New Year's Day.  The whole idea of out with the old, in with the new brings me great hope.  This is the time when I take pen to paper and make my list of resolutions that I hope to bring to fruition within the next twelve months.  I know I am not alone.  Typical resolutions usually include getting into physical shape, eating healthier, getting your finances in order and the like.  If you keep just one of these resolutions this year, make it getting your finances into shape, for retirement that is.

Just like getting into physical shape takes vision, a plan of action and discipline, so does investing for retirement.  Whether you are just starting out in the work force or are a more seasoned worker, it is never too late to start saving for retirement.

The question of how much you need to save depends on a number of factors such as:

• How much do you have saved so far for retirement?
• How many years do you have until retirement?
• What will your income needs from your portfolio be in retirement?
• How many years to you expect to be in retirement?

The first and most obvious place to start saving for retirement is via a 401(k) or 403(b) plan through your employer.  For these types of plans, annual employee deferrals are $15,500 ($20,500 if you are over age 50) for 2007.  There are two great things about these plans.  The first is that the employer typically matches a portion of your contribution up to a certain percentage, usually 3%.  The second is that deferrals to these plans are tax deferred and reduce your current taxable income.  If you cannot afford to defer the full $15,500 or $20,500 to these accounts, defer at least enough to get the employer match.  This is FREE MONEY.  And I don't know about you, but I love free money.

The latest twist to these plans was the introduction of the Roth 401(k).  This plan differs from traditional 401(k)s in that you pay tax now on the deferral and when you take the money out at retirement, it is tax free.  Use of the Roth 401(k) is especially beneficial to individuals who expect their income to increase in the future and wish to pay taxes now at theoretically lower rates.  Other tax deferred vehicles to take advantage of in saving for retirement are Individual Retirement Accounts (IRAs).  Contribution limits for these accounts are $4,000 ($5,000 if you are over age 50) for 2007.  If you have contributed the maximum to these types of accounts and want to accumulate more, use brokerage accounts.  Although they are not tax deferred, if you keep your assets for more than one year, you will get a reduced tax rate of 15% on the capital appreciation once you sell the positions.

Now that you have decided how much you can afford to defer or contribute towards retirement, you need to assess your risk tolerance.  Some people are extremely risk tolerant and are willing to bet the farm (and then some) in hopes of hitting the "jackpot".  Others are more risk averse and would rather see their investments grow more moderately but consistently throughout the course of the accumulation phase.  This is a personal decision and one you should be comfortable enough with to sleep soundly at night.  If you are very young and have 20, 30 or 40 years to retirement, take more risk, invest in a portfolio of 100% equities.  You have the benefit of time on your side.   If you are older and have fewer years to save and are more risk averse, a more moderate asset allocation may be appropriate.  Remember, however, that in both situations, you need your assets to grow.  By default, this means investing in equities to some degree.  You cannot expect your assets to grow and provide you with income during retirement if you are invested 100% in fixed income.  The tendency is to invest as aggressively as you are comfortable with during the accumulation phase and then slowly transition into a more conservative model by the time you are actually in retirement, say 60% Equities and 40% Fixed Income.

At this point in the process, you have an annual savings target and an asset allocation.  The next step is to decide what your investments should be.  Believe it or not, this might be the easiest decision you will make thus far in the process.  Wall Street and pay-by-commission brokers will try to sell you on the latest "hot stock" or actively managed fund.  But buyer beware, the key to accumulating wealth for retirement does not lie in the next hot stock, but in index funds.  Investing in low cost index funds is the most efficient way to invest for retirement.  By purchasing a handful (10-15) of index funds and/or exchange traded funds, you can capture global markets at a fraction of the price you would with actively managed funds.  By default, index funds are low cost because there is no traditional "management" of the fund.  The fund is created to track an index.  That is, the fund does not have a manager(s) deciding which companies' stocks to include in the fund.  This reduces the fee significantly.  When choosing index funds, don't just invest in domestic funds.  By introducing international and emerging markets you increase diversification and the potential for growth while simultaneously reducing the overall risk of your portfolio.

Let's take a look at what different annual investment amounts would grow to assuming that you started with $0 and averaged an 8% return on your investment:

Years to Retirement	Annual Contributions
	$4,000 to IRA		$15,000 to 401k		$19,000 to IRA and 401k
10	$   57,946		$ 217,298		$275,045
20	183,048		686,429		869,477
30	453,133		1,699,248		2,152,381
40	1,036,226		3,885,848		4,922,074

* These amounts assume annual compounding

These are some impressive numbers!  Obviously, the earlier you start and the more you save, the bigger your nest egg will be at retirement.  But even increased contributions later on in life will provide you with needed funds.

Just like getting in shape, investing for retirement takes discipline.  Sign up for or increase your deferral to employer sponsored plans.  Request that a portion of your check be automatically deposited to an IRA or savings account.  When you don't see the money hitting your checking account, you don't miss it as much.  Sure the first paycheck of the year may seem paltry, but you would be surprised how quickly you learn to make due with the reduced amount.  Make it your 2007 resolution to get in shape, at least for retirement.

 

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