Retirement Planning, Part 3: Investing for Retirement
Eileen St. Pierre, The Everyday Financial Planner
You have been saving for retirement, but you really don’t understand how to invest the money. That retirement calculator you used assumed a rate of return on your investments but you have no idea how they came up with that number. With more employers switching from pensions to defined contribution plans like 401(k) and 403(b) plans, the burden of investing for retirement is increasingly falling on the shoulders of employees.
Keep It Simple
Most of you have heard the expression “Don’t put all your eggs in one basket.” You want to hold a diversified portfolio. But this does not mean you have to hold a lot of different investments. Use mutual funds. Mutual funds pool your money along with other investors and buy diversified portfolios for you. For example, an S&P 500 mutual fund would buy the stocks that make up the S&P 500. By owning the mutual fund, you indirectly own all the S&P 500 companies without the hefty trading commissions.
You really only need two types of investments in your retirement portfolio: stocks and bonds. Bonds are the debts of corporations or governments. Bondholders are considered creditors. They get paid interest (usually semi-annually) and expect to get their initial investment (called the principal) back when the bonds mature. Failure to pay interest and return the principal can throw the company or government into default.
Stocks are shares of ownership in the assets and earnings of a corporation. Owners of any business are paid last, after everyone else – Uncle Sam, employees, suppliers, and creditors. For this reason, stocks are considered riskier than bonds. Stockholders may get dividends (usually paid quarterly but not required), and hopefully will see their stock rise in value for a capital gain. A mutual fund that holds stocks that pay relatively large dividends may be referred to as an income fund, while one that holds stocks that are expected to provide strong capital gains is called a growth fund.
According to TIAA-CREF, over the period 1926 to 2010, stocks averaged 9.87% annually, while long-term corporate bonds averaged 5.93%. Inflation averaged about 3% a year. So if your retirement portfolio has to grow enough over a long period of time to cover inflation and rising health care costs, you need to make sure you have enough invested in stocks.
Understand Your Risk Tolerance
Before you do any investing, you need to understand your tolerance for risk. How would you feel if your portfolio dropped 5% in one day? On a $100,000 portfolio, that’s a loss of $5,000. The stock market can be a roller coaster ride. If you are not prepared to hang on for the long-run, you need to pick a more conservative asset allocation.
So how much money do you allocate to stocks and how much to bonds? If you have a low tolerance for risk, use this conservative formula: Put (100-age)% in stocks and the rest in bonds. If you feel you can handle a bit more risk, put (110-age)% in stocks and the rest in bonds. As you age, you will need to shift money away from stocks into bonds. But you always need to have some money allocated to stocks to make sure your portfolio keeps growing. You may want to further increase your stock allocation if
- you started saving late – to make up ground.
- you have a pension at work – since part of your retirement income should be guaranteed, you can afford to take on more risk.
Many people never revisit their portfolios after making their initial allocations. For these investors, target date funds (also called life cycle funds) are ideal. These funds will automatically adjust your allocations as you age. Pick a target date close to your expected retirement date. For example, a 45-year old may pick a target date 2030 or 2035 fund (usually in 5-year increments).
- The riskiness of these funds can vary greatly across investment firms. Read the prospectus! Stay away from funds that allocate more then 50% of your money to stocks at your retirement date.
- Keep in mind their chosen stock allocation will likely be greater than (110-age)%.
- Remember, the closer the date, the lower the stock allocation. So choose an earlier date if you want to lower your risk.
Your retirement portfolio represents a long-term investment. Even if you are already retired, you may live another 25 to 30 years. A common reason why people run out of money in retirement is because they failed to take enough risk.