Six Key Principles of Saving for Retirement

Ben Stein has an good read on Yahoo Finance about what he terms the Six Key Principles of Saving for Retirement. Although I agree with all six main ideas, I question some of the specific numbers. Here are some excerpts and my comments:

1. How much you save.
Simply put, if you’re a typical American (who happens to save close to zero right now), you have to save more. When you’re young, 10 percent of your income will get you there. If you don’t start saving until middle age, aim closer to 15 or 20 percent. If you don’t start until later than middle age, save every penny you can.

Interesting. Is 10% really enough? If so, maybe I really am saving too much for retirement. :) To what degree of certainty is that true?

2. How long you give your savings to compound.
A thousand dollars socked away when you’re 20 and growing at 10 percent per year will be almost $73,000 when you’re 65. The same sum saved when you’re 50 will grow to $4,200 at age 65. That’s a stunning truth that should compel any young person to start saving early — and the rest of us to start right now.

As for timing your retirement, Ray advises that if you can push it back by even five years you’ll allow your money to grow and have fewer years to need it.

Compound interest is truly powerful. A dollar saved now is worth more than a dollar saved later.

Although it hasn’t been helping me control my spending as much as I’d like either, I did make the horribly unpopular true cost of frivolous shopping calculator. ;)

3. How you allocate your assets.
Typically, for those who start early, stocks are the answer. Over long periods, a diversified basket of common stocks wildly outperforms bonds, cash, and real estate. The differences are breathtaking.

But, as we’ve seen lately, there’s also a lot of volatility in stocks. As you age, you’ll want more of your money in bonds and money market accounts. These have lower returns than stocks, but they also have far lower volatility.

Phil DeMuth recommends that, as a basic portfolio, you have half of your savings in the broadest possible common stock index such as the Vanguard Total Stock Market Index (VTSMX) and half in the Vanguard Total Bond Market Index (VBMFX)… To me, that’s a bit conservative if you’re young. I would have more in stocks and also a good chunk in international markets.

Here is a compilation of various model asset allocations from other respected sources. Pretty pie charts included!

4. How much your investment returns annually.

Now, this is largely unknown from year to year. But over long periods, stocks return close to 6.5 percent after inflation, and about 10 percent before inflation.

Can we expect 6.5% real returns in the future? Lots of conflicting opinions out there on this, but I really want to look into this more.

5. How low you keep your fees and costs.

This principle is largely about using index funds and no-load mutual funds, which makes perfect sense.

Costs matter, whether you go actively or passively managed. I’ve seen some really expensive index funds. Always look up the expense ratios and any commissions you have to pay either when you buy or when you sell for all the investments you own.

6. How closely you keep an eye on taxes.
Finally, Ray advises maxing out your tax-protected accounts like IRAs and 401(k)s; keeping high-dividend stocks in accounts that are tax-deferred; and, when retiring, carefully considering what bracket you’ll be in and drawing out your funds to remain in the lowest possible one.

Ah, taxes. Here is a discussion on where you should place investments for maximum tax-efficiency.

J.D. of Get Rich Slowly also shared his thoughts on these six points, and believes the most important factor in retirement savings is psychological.

Comments

  1. I ran a quick test. Assuming your income is constant and you want to withdraw only 4% of your savings in retirement, and you want that to be 80% of your income, then saving just 10% (even with his favorable 6.5% real returns) is on the low side unless you have at least 42 years to retirement.

    If you assume a more conservative 5% real ROR, and 35 years to retirement, then you need to save 22%.

    On the other hand if you are 45 years away and you drop the ROR to 5% you only have to save 12%. Thus the magic of compounding interest shows that you don’t need to save as much even if you get lower returns.

    Of course the ‘goal’ numbers I assumed are fairly nice, and most people I’m sure could do with less.

  2. OppositeGuy says:

    When I was in my 20′s, i decided to take the opposite apporach in saving for retirement. I dont know if what im doing is right or will have a negative effect on me when i retire. I am 32 years old now and my wife and I only have $25,000 in our retirement accounts. However, our liquid net worth is around $330,000. (after 7 years of working)

    We are so confused whether to pay cash for our home or take a mortgage. Our money is earning around 5% interest.

  3. OppositeGuy: When you say “liquid net worth ” of 330k earning 5%, I am assuming you have it in some high yield saving/MM account or a CD. At age 32, that is commendable (regardless of whether you have it in retirement a/c or otherwise).

    That said, couple of things you can do now:
    First, if your 330k is in a single bank, FDIC insurance may not cover the whole amount, in case the bank were to go under (not common but does happen). Try to split it into 2-3 bank so that each has under 100k (or 200k if you have joint accounts).

    As for whether to pay cash for a house, it depends. If you are going to have the 330k in “liquid investments” (MM, high-yield savings or even CDs), best return you can expect is around 6%, taxable as ordinary income. So it makes sense to use most of the 330k (less whatever you feel comfortable for emergency fund and new home furnishing etc.) towards downpayment for the new home.

    On the other hand, I would suggest that you invest a good portion of the 330k in stocks and bonds (assuming you dont see a need for the funds for at least the next 5-10 years). Leave some out for a downpayment (I would say at least 20% of the cost of the house) and an emergency fund and put the rest in stocks/bonds. If you have not invested in stocks before and dont know where to start, simply open a a/c with one of the mutual fund companies (Vanguard, fidelity are good choices) and put it in some diversified stock index funds (e.g., S&P 500 index, Total market index, maybe part in international equity index etc.). You can put a smaller portion in some bond funds if you wish. Over the long run, you can expect a good 8-10% return on these investments.

    For the future, I would try to maximize contributions to 401(k) (if your employer offers it) and IRA accounts. But the fact that you have saved well over 300 grand in a short period of time is what is significant and not that you have only 25k in your retirement a/c.

  4. “…over long periods, stocks return close to 6.5 percent after inflation…Bogle…says…that you’ll do best as a stock investor with index funds that cover the largest possible universe of stocks in the free world…”

    I generally like the personal finance stuff that Stein writes for yahoo and the NYTs, but here he’s mixing data sets.

    True enough, the U.S. market returned around 6.5% real over the past century, but we were by far the outlier (perhaps because of the absence of market “interruption” from economically destructive war and/or cataclysmic social unrest). The “universe of stocks in the free world” showed about a 4% real return over the same period.

    So, if the future looks like the past, figure 4% real for stocks and 1.5% real for fixed income. Subtract another .5% for expense ratios and internal fund operating costs (if you’re using Vanguard index funds and triple or quadruple the costs if you’re not), and you’re left with very slim margins indeed.

  5. Has anyone ever compared the investing & retirement strategies of those who believe in god and those who don’t? Other than the obvious 10% tithe bonus I save (thats a joke – haha), I think it might not be too different.

    As a member of the latter, my goal is to retire comfortably (not necessarily wealthy) as soon as possible. Early retirement will give me more time to travel, spend time with the family and I can always pick up a part-time job with no real responsibility if I need a few extra bucks (not that I want to, but I might get bored).

    I like my job, its enjoyable and pays well, but I wouldn’t go if I didn’t need the check. Right now, we’re maxing out Roths and putting 10% into 401k (company matches 100% to 6%). We take all savings off the top so its not an option to spend it. Of the remaining monthly cash, we do enjoy a pleasant quality of life (I think its necessary).

    I’ve been thinking of living off my inital roth investments while waiting for the big 401k to be free of taxation. I don’t want to work past 55 if at all possible. I plan to distribute any excess wealth before I’m dead.

  6. OppositeGuy says:

    KS,

    Thanks for your tips. I will look into the mutual fund (possibly total market index) as u suggested. I am a very cautious investor (when it comes to stocks etc).

    People must be thinking that we managed to save that amount because of our high salaries. But the fact is 6 out of the 7 years of earning, our combined income was only $95,000. So to all those people out there, it is not what u earn, but its what u save. I followed a very good tip i read somewhere. Right after graduating from College, try to continue living like students for at least 5 more years. And thats what we did. We lived like students for 6 years.

  7. “Always look up the expense ratios and any commissions you have to pay either when you buy or when you sell for all the investments you own.”

    I would also add that one should look at the stock turnover rate of a given fund. Trading fees and bid/ask spreads are a hidden fee that mutual fund investors often ignore or forget.

  8. Saving Simply says:

    In my experience, saving as early as you can is probably the single most important thing that you can do to increase your net worth. Upon graduating from college, my lifestyle went from basic to extremely spartan, and I then proceeded to live out of my car for a year (while working several jobs). Aside from all the other more interesting reasons that I lived in this manner, the monetary benefits of the experiment turned out to be extremely significant. (What I’ve done is not something that is reasonable for the average person to do, but can serve to illustrate the benefits of saving early)

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