Retirement Planning

It's Never Too Late

by Amie A. Bonner

When it comes to retirement planning, people generally fall into three categories: (1) those well on their way (they zealously save, and they monitor their savings frequently), (2) those who save some but don’t have set goals or clear plans for reaching their goals, and (3) those who haven’t started saving at all. If you fall into the first category, I have little new information for you. If you haven’t already talked to a financial planner, however, I recommend doing that, so you eke out every last penny from your investments. If you find yourself in the second or third category, read on. I’ll help you determine and achieve your retirement goals.

Generally, the mantra for retirement planning is “save early; save often.” But there’s more to it than just saving. Planning how much you’ll need can help you decide how much to save and where to invest. It is possible, in fact, to save too much. If you are saving more than you need to reach your goals, you may not be left with enough money to enjoy life right now. To guide you toward efficient and productive retirement savings, I suggest following four steps: (1) plan, (2) execute, (3) monitor, and (4) update.

Step 1: Plan
Let’s say you want to retire at age 65 and aren’t sure how much to save. Here’s a good rule of thumb: Plan to save 25 times your retirement salary. Your retirement salary is usually about 80% of what you are making when you retire. The 20% shortfall is accounted for by savings and minor expenses that you won’t have in retirement. For example, assuming a pre-retirement salary of $80,000, you would expect to need a retirement salary of $64,000 and so should have $1.6 million saved by the time you retire. This is, of course, a rough estimate, but it gives a good idea of the magnitude of your goals.

That sounds like a lot, you say? Well, keep in mind that the $1.6 million is in today’s dollars. To find the “true” total amount, you must take inflation into account. Historically, inflation has averaged 3% to 4%. To calculate your “true” retirement goal, take the goal in today’s dollars and multiply by 1.04 (for 4% inflation) for each year until you retire. For the example used earlier, if you are 45 today and plan to retire at 65, you must save $1.6 million * 1.04(65–45), or $3.5 million. Likewise, your retirement salary in 20 years will be $64,000 * 1.0420, or $140,000.

Now that you’ve figured out how much you need to save by retirement, it’s time to calculate how much you should be saving now to reach that goal. This is fairly difficult to do with just paper and pencil, so I recommend using an online calculator: T. Rowe Price has a good calculator. However, it returns a constant annual savings amount rather than one that increases each year. If you plan to increase your savings each year (for example, if your 401k contribution is a percentage of your salary, it will increase when your salary increases), you can save a little less now to offset the extra you’ll save later.

Another good calculator is available at MSN Money. This one allows you to enter your current savings information and outputs your net accumulation in, as well as withdrawals from, your retirement accounts. Playing with the inputs can show you the sensitivity of your net accumulation to growth rate, savings rate, age at retirement, and length of retirement. All numbers are in today’s dollars, so you should apply the equation we used earlier to account for inflation.

Finally, once you know the amount you must save by retirement, then to maximize the return on your investment, you must decide where to invest. Depending on how close you are to retirement, the amount of risk you can afford will vary. Your portfolio should be divided between volatile (risky) but lucrative (high-yield) stocks and more conservative (less risky) bonds. Here’s a guideline for the percentage of your portfolio that should be invested in stocks: 100 minus your age. If the investor is 45, as in the example, her portfolio should generally contain about 55% stocks and 45% bonds. This ratio of stocks to bonds should gradually shift as she nears retirement, to minimize risk. Some investment firms are now offering mutual funds geared toward a certain retirement date. As that date nears, the composition of the fund shifts to a more conservative allocation. It’s a sound idea to do some research on the funds available to you. A good place to start is the Web sites of various reputable investment firms (see sidebar).

Step 2: Execute
Once you have a good idea of how much you need to save each year, it’s time to start socking it away. If your employer offers a 401k plan, I highly recommend that you participate. Set up automatic deposits from your paycheck; this eliminates the temptation to spend rather than save. In addition, your employers may match some portion of your contribution, effectively increasing your overall salary. Not taking advantage of this is like giving up free money.

Among other options for retirement investments are tax-deferred IRAs (individual retirement accounts) and Roth IRAs. Tax-deferred IRAs work like 401k plans in that you make contributions before your income is taxed. With a Roth IRA, you make contributions after you are taxed, but the balance grows tax-free. Generally, if you think you’ll be in a lower tax bracket during retirement, you’d want to invest your money in a tax-deferred account; otherwise, a Roth IRA will help you save the extra taxes you would have to pay on your withdrawal later.

A good first plan of attack is to invest enough in your 401k to get the maximum employer matching contribution. (If your employer matches half of your own contribution up to 6% of your salary—which would be 3% of your salary—then make sure you are contributing at least 6% of your salary. It’s like getting a 3% raise!) Then your additional savings can be diversified into a tax-deferred or Roth IRA, or can be added to your 401k. For information on IRAs and other types of retirement accounts, I advise that you visit the Web sites listed earlier.

Steps 3 and 4: Monitor and Update

Now that you have your investments rolling, just sit back and relax. As you move closer to retirement, you’ll want to shift your portfolio from stocks to bonds to cut back on the risk. If you’ve invested in a target-date retirement fund, this shift will occur automatically. Otherwise, it’s important to research your options and shift your funds accordingly. It’s also important not to be too overzealous with your investments. Retirement savings are meant to grow over a long period. Investing in the latest fads to earn a quick buck and using your retirement accounts to play the stock market are quick ways to undo years of returns on your investments. Each year, check whether you are still on track to reach your retirement goals. Then adjust your savings rate accordingly.

The four steps presented here are a good jumping-off point for retirement savings. Keep in mind that it’s important to research mutual funds before investing in them, to determine if they match your requirements. In addition, once you’ve established a baseline retirement plan, you may want to contact a financial planner to work out the details and maximize your returns. For more in-depth information on retirement planning, see the Web sites in the sidebar. They offer a world of information to prepare you for the decisions that lie ahead!

Amie Bonner is an aeronautical engineer with Lockheed Martin, in Palmdale, California. When she’s not designing airplanes, she’s calculating her investments and planning for retirement (which is a long, long way off). Um, and she also advises her parents to do the same.