When and How to Start Preparing for Retirement
When you are starting out your career, and just out of school, the idea of retirement seems farfetched. Most cannot imagine a day when they are no longer working or able to work. But retirement is a part of life. And if you plan properly, it can be a wonderful moment. The start of a new chapter in your life, bolstered by the money that you carefully saved, invested, and accumulated over decades during your work life. With only a small percentage of employers offering pension plans these days, it pays to plan ahead.
Why Aren’t We Saving More?
The National Institute on Retirement Security estimates that 40 million households in the United States have no retirement savings. According to the Employee Benefit Research Institute, Americans are collectively at a retirement savings deficit approaching $4.3 TRILLION. The number indicates that households in the United States, where the head member is between 25 and 64, have $4.3 trillion less saved than the suggested number.
The Federal Reserve has further alarming statistics on our lack of retirement savings. The median retirement account balance in the country is $59,000. That only includes people who have a retirement account. Consider the tens of millions who have not even set one up. The mean balance for retirement accounts is $200,000. Remember, median is the middle point of the number set, while the mean is calculated by adding up all the numbers and dividing by the amount in the set.
There are some American households that are well set up for retirement. That is why the mean is higher. But the median indicates just how many households fall at or below that $59,000 threshold. $59,000 would barely cover a medical emergency, let alone set someone up for retirement. Every American of working age should be alarmed if they are not already preparing for retirement.
Best Age to Start
There is a misconception that we should only start worrying about retirement in our late 30s and early 40s. Those are the years when you are established in your career, and you start to make good money. Now you can begin investing for retirement. But if you are just getting started in your late 30s, you have missed out on 10 to 15 years of savings that could have been in your retirement account.
Starting a retirement account is not a milestone you leave for your 30s. It should happen the moment you begin working. Whether you join the workforce at 18, 22, 25 or later in life, set up a retirement account within a year of your first job. Even if you are only adding small amounts to the account at first, every dollar that you save will help you down the road.
Advantages of Starting Young
It is understandable that you earn less when you first enter the workforce. And if you graduated from college, you may have some student loans that need paying. No one is expecting you to put $10,000 into a retirement account every year in your 20s. But even adding $1,000 each year is a very valuable amount.
Focus on managing your debt, and do not fall behind on any payments because you put money into a retirement account instead. But manage your spending so that you are enjoying your life, paying off your debts, and putting a few hundred dollars into your retirement account each time you have some extra savings. The earlier you add money to your account, the more you can get out it.
Benefits of Compound Interest
The biggest reason why you should begin adding to your retirement nest egg in your 20s is compound interest. Compound interest is how money grows exponentially because interest builds on top of itself. The idea is that you are reinvesting the earnings that you get from your initial investment.
We can use a simple example, where you decided to add $500 into a long-term bond that is rated as very safe. It is a no-risk investment where you know that you will get some return every year. Even if the return is only three percent annually, it is still some interest.
At the end of your first year, you have $515 thanks to the three percent interest. In the second year, you have $515 in that bond, which means you end up with $530.45. Within two years, you only gained an extra $0.45 thanks to compound interest. Not impressed?
Within ten years, your $500 investment in a practically risk-free bond will turn into $671. In 40 years, the same $500 investment is now $1631. You can plug in your own figures to calculate the impact of compound interest into a calculator, such as this one from the United States SEC.
Now imagine that you are adding more than $500 to your retirement account each year from your mid-20s, and you are putting a lot of that money into investments that give you a much better than three percent return. It is easy to see that money quadrupling by the time you are set to retire.
Risking More at a Young Age
When you are in your 20s, you could imagine yourself working for another 40 years. It gives you four decades worth of money you will earn and invest through a retirement account. And if you started saving early, you get the chance to take more risks. Sure, there is a chance some of your investments will not pan out. But the ones that do will give you a very good windfall. And even if you have a year where you end up losing more than you make on those investments, you have plenty of time before you hit retirement age.
Taking big risks with your retirement savings is not so wise when you are in your 50s and 60s. You can always take calculated risks, where you are confident you are backing a winner. But you will not want to risk the nest egg you have already built up. That is what your 20s are for!
The two most popular options for investing retirement funds are individual retirement accounts, or IRAs, and 401(k)s.
The concept of a 401(k) is that your employer will make contributions to the retirement account on your behalf. Those who are loyal to a single company, or could envision spending many decades at the same firm, would benefit from a 401(k).
There are a few different types of these plans, with 401(k)s being the corporate version. A 403(b) is designed for employees that work in public education or with nonprofits. A 457 is where state and municipal employees’ money is put aside for retirement, while federal employees get Thrift Savings Plans, or TSPs. The only difference between these plans is who can use them.
The IRA is a savings account that you would use for retirement. The reason why it makes sense to use an IRA, instead of a regular savings account, is because you get enormous tax benefits on the IRA. Some people think the IRA is the investment, but the IRA is just the place where you are putting all your money and assets. Whether it is stocks, bonds, mutual funds or commodities, they fall within the IRA umbrella.
There are a few different IRAs, such as traditional, Roth, SEP and SIMPLE IRAs. These differ based on income eligibility, employment status, caps on how much you can put into the account each year, and how the tax breaks are given out. For instance, tax is only paid on retirement in a traditional IRA. Meanwhile, you pay tax when the money goes into the account in a Roth IRA, but pay no tax at retirement.
Before setting up a retirement account, research all the differences and eligibility restrictions on the accounts to ensure you select the one that is best suited for your needs.
Retirement Planning Video
How to Invest the Money
Now that you have a retirement account set up, it is time to decide how you will invest your money. As mentioned earlier, going for riskier investments in your 20s and early 30s is a sensible choice. Some individuals go the route of selecting specific stocks and/or bonds for their retirement savings, while others rely on mutual funds with differing returns and risk levels.
According to Morningstar, the average annual return on the stock market between 1926 and 2015 came in at 10.02%. In contrast, the average annual return on bonds from the same period stood at 5.58%. While you get a decent return on bonds, stocks offer a lot more chances for exponentially growing that retirement nest egg.
Individuals who have experience and understanding of the stock and bond market can pick specific investments to add to their portfolio. Those who do not wish to take on so much work can still be very successful by choosing the right mutual funds or other investment vehicles suggested by a Certified Financial Planner. For the first ten years of retirement savings, assuming you start in your 20s, going for mutual funds with higher annual returns is the best decision.
Even when investing in risky mutual funds, it is good to have some balance. Do not put 100 percent of your savings into risky mutual funds at any age. Balance it out by having 50% in high return mutual funds, 30 percent in “safer” mutual funds, and 20 percent in bonds. You can revisit those percentages every few years, depending on how much you are saving, the returns you get, and any change in your life or employment circumstances.
It is tempting to invest almost all your retirement nest egg in bonds when you are approaching retirement. But assuming you plan on living for a couple decades after retirement, it can help to keep growing that nest egg. In your late 50s and early 60s, putting 40 to 50 percent of your money in stocks, and the other half in bonds is a sensible option. You still get the nice returns from stocks/mutual funds, but you get the safety net of bonds should something go wrong with the stock market.
How Much Do I Need?
The question many people ask is how much they will need in their retirement nest egg when they stop working. The answer is that each family will have their own number. Your ideal retirement figure will depend on where you live, the lifestyle you want to enjoy, how many years you want to spend retired, and how many dependents you have.
There are useful retirement income calculators, such as this one from TD Ameritrade, you can use to get some idea of your ideal figure. The calculator considers your current age, when you expect to retire, how many years you plan to spend retired, and how much money (in today’s dollars) you will need to live each month at retirement.
Consider Health and Life Insurance Policies
Life insurance is about so much more than getting a lump sum amount when someone passes away. Life insurance should be an integral part of any retirement plan. When used correctly, life insurance can help solidify a family’s retirement plan and protect it against unforeseen incidents.
Say both people in a couple are working and saving toward a joint retirement. If one spouse passes away unexpectedly, their potential income is lost. While the other spouse may have slightly lower expenses as a single person, they are still in the red because of the unexpected income and retirement benefits losses. The money from a life insurance policy is a way to offset those losses and ensure the surviving spouse and family still have the means to live and retire with their current lifestyle.
Health insurance costs are also important to consider. When we are younger, it is tempting to go without health insurance. But having an affordable health insurance policy throughout your life is a wise investment decision. It ensures protection from the costs of regular health checkups, doctor visits, prescription drugs, and emergencies. Some type of supplemental health insurance is also beneficial, as those policies have very low monthly premiums and provide lump-sum payments in specific cases – say an accident, disability, cancer diagnosis or another health emergency.
As we get older, it is sensible to bolster our health insurance policies every few years. Going with the higher premium plans later in life is wise, as they provide a higher level of coverage, and less out of pocket expenses when you do need treatment and/or hospitalization. We tend to get sicker as we get older, and having more health insurance in those years is very helpful.
It is scary to start thinking about retirement in your 20s. You just started working, and you want to enjoy the money you are earning. But decades pass in the blink of an eye. And before you know it, you are approaching retirement with a nest egg that is not big enough. Start early, and you have a much better chance of ensuring that you and your family are financially secure when you decide to stop working.
Maeda, Martha. The Complete Guide to IRAs and IRA Investing: Wealth-Building Strategies Revealed. Atlantic Publishing Group, Inc. 2010.