The Basics of Saving for Retirement

Posted on Updated on

Here is a review of the basic principles of investing for retirement:

  • Start saving as early as possible because to get rich slowly you need to take advantage of compound interest. Albert Einstein (might have) said, “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t pays it.” Compound interest is earning an investment return not just on your initial investment or principle, but also on your previous return. In other words, if you invest $1,000 and earn a 10% return yearly, after the first year you’ll have $1,100.  The second year you’ll earn 10% on your initial $1,000, but also on the $100 you earned during the first year, leaving you with $110 of earnings during the second year instead of $100 like the first year. Over a long period of time, this phenomenon greatly increases the amount of money you can accumulate with your investments. Because of this, time spent in the market is much more important than trying to time the market by buying and selling at the right times. The long-term return of the stock market is approximately 9.5% per year. Adjusting for 3% inflation, $1 invested grows to: (Ref: Bogle)
    • $1.88 in 10 years
    • $3.52 in 20 years
    • $6.61 in 30 years
    • $12.42 in 40 years
    • $23.31 in 50 years
  • If you find it difficult to save, set up an automatic investment plan so that the money is automatically removed from your pay and you never get a chance to spend it.
  • Investment costs and taxes matter in the long run and will never end; therefore both must be minimized as much as possible. You can minimize both by investing in low-cost stock and bond index funds and maximizing your contributions to tax-preferred retirement accounts.
  • Long-term investment in the stock market is the surest way to make your investment grow over time and beat inflation. By owning stocks you own businesses, and the long-term return of these businesses is what will increase your investments and net worth. Trading stocks is not the goal…owning them is.
  • As you progress toward retirement, you will decrease your investment risk by decreasing the amount you invest in stocks and increasing the amount you invest in bonds.
  • The optimal allocation of investments depends on your age, financial situation, risk tolerance, and how soon you will need to utilize the investment. If you are young, you have longer to ride out the inevitable market swings. The more financially secure you are, the better you can deal with the swings as well. Your asset allocation should also reflect the amount of risk tolerance you have. My opinion is that early in your career you should take as much risk as you can tolerate. If you can’t sleep at night because you are worried about your investments, it is time to dial down the risk, but you should take as much risk as you can up to that point. More risk yields a higher return over the long-term.
  • You should utilize dollar cost averaging to decrease your investment risk. Dollar cost averaging is when you purchase the same dollar amount of investments periodically over a long period of time. It provides time diversification, ensuring that you don’t buy all of your investment during a time of temporarily inflated prices. In volatile markets that are going up and down, it will actually increase your investment return because it ensures that you purchase less shares when the investment is expensive, and more when it is cheaper.
  • The market will go down, and when it does you need to resist the temptation to sell investments or stop investing. The best time to buy an investment is when it is cheap and you can get the best deal. When the market recovers, which it will, you will reap the rewards. Focus on the long-term and just keep investing.
  • Every time you get a raise, bonus, or income tax refund, use it to increase the amount you invest for retirement. You should save at least 15% of your gross or pre-tax income for retirement, but if you want to be rich or retire early you’ll need to save 20-30%.
  • How much money will you need to retire? Most retirement planners state that you’ll need approximately 70% of your pre-retirement income to maintain your current standard of living once you retire. This number, though, is heavily dependent on what you consider to be a “good retirement” and what type of a lifestyle you intend to lead. For example, since I save 30% of my gross income for retirement, I’m already living on only 70%, so I highly doubt I’ll need that much when I retire. If you are frugal and pay off your mortgage, you may find that you need as low as 25% of your pre-retirement income to retire comfortably. You won’t be staying in the Ritz Carlton, but there’s nothing wrong with the Hampton Inn.
  • There is a lot of uncertainty in life, but the 4% rule is a nice rule of thumb to use when assessing how much money you’ll need to accumulate before you can retire. The 4% rules says that you can take 4% from your retirement savings annually, adjust for inflation each year, and never run out of money. The devil is in the details, but use the 4% rule and assume that you can get approximately $40,000 per year of retirement income from every $1 million you have saved.
  • Saving for retirement is your top savings priority, even over funding the college education of your children. You can borrow money to pay for college, but you can’t borrow money to retire.
  • You must maximize your contributions to tax-preferred retirement accounts, such as 401(k), 403(b), Simplified Employee Pensions (SEPs), or Individual Retirement Accounts (IRAs) every year. The tax benefits of these plans are staggering over the long-term: (Ref: Malkiel and Ellis)
    • If you invest $5,000 per year over 45 years and earn an 8% return with no taxes paid until withdrawal during retirement, you will have a final portfolio value of over $2 million. If you pay 28% taxes at withdrawal, you’d have almost $1.5 million.
    • The same savings without the benefit of tax deferral will top out at about $750,000.
  • If you work as an independent contractor you have more options than a physician who works as an employee, so hire an experienced tax or health care attorney, accountant, or fee-only financial planner to set up the best options for retirement investments if you are uncomfortable doing this on your own. It is probably going to be easy, though, and you just need to open of a solo/individual 401k with an investment company.
  • NEVER use retirement savings for anything other than retirement unless it is absolutely unavoidable. Again…you can’t borrow money for retirement.

References

Bogle, John C. The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns. Hoboken: John Wiley & Sons, Inc., 2007.

Malkiel, Burton and Charles Ellis. The Elements of Investing: Easy Lessons for Every Investor. Hoboken: John Wiley & Sons, Inc., 2013.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s