The 1-2-3 Money Plan Part 20

Retirement.

Retirement investing for individuals is relatively new. A generation ago, most people had defined pensions, which meant that when you retired, you got a check every month. It was someone else's job to invest that money. Today, you're responsible, like it or not.

Retirement, 1-2-3.

1. Invest automatically. Invest 10 percent of your income into a retirement plan, such as a 401(k) or Roth IRA.

2. Diversify. Invest all the money in a target-date retirement fund closest to when you'll retire.

3. Hold on. Never touch the money until you retire.

"Come on," you're thinking. "Entire books are written on retirement investing. How can it be this simple?"

It can. For the vast majority of people, this simple plan will work wonderfully. It's "good enough" to ensure you're saving for a respectable retirement. Of course, you can tweak this simple plan along the way, and probably should. But not doing these steps, or ones very similar, could mean you're in for a rough time in your golden years.

Just because it's simple, doesn't mean it's unsophisticated. And it certainly doesn't mean it's inferior. In fact, with investing, the more complicated things get, the more likely you'll be railroaded and some money manager is going to get rich off you.

Getting started with retirement saving is as easy as visiting your human resources department at work or going online to sign up for a retirement plan. If you started a new job, your employer might have enrolled you automatically. If you already have a retirement plan started, you can still use these steps by modifying your contributions and allocations.

How big of a retirement nest egg do you need to build? Whatever number you come up with is simultaneously supremely important and utterly meaningless.

You could a.s.sume you'll spend the same amount of money you do now, adjusted for inflation. But how reasonable is that, especially if you're in the wildly expensive raising-a-family stage of life?

Expenses in retirement often decrease. For example, you won't be funneling money into a retirement plan, child expenses are gone, and perhaps you paid off the home mortgage. On the other hand, you might need more money for traveling, recreation, and medical care.

Online calculators are a help in determining what you need because the math is complicated to do by hand. The more detailed-and unfortunately, tedious-the online questionnaire, the better your estimate will be. Examples of online calculators include the following: * www.Fidelity.com/myPlan * www3.troweprice.com/ric/RIC * www.d.i.n.kytown.net * www.choosetosave.org/ballpark * www.aarp.org Financial software, such as Quicken, also has retirement tools.

But realize that any dollar figure you come up with is just an educated guess. The best professional financial planners can only speculate about what the total dollar figure for your nest egg should be and what you need to be saving along the way to acc.u.mulate that dollar figure. That's because of the unknowable a.s.sumptions. These include everything from how long you'll live, to inflation rates, to what return your investments will earn. But an informed estimate is far better than none at all. It will give you a ballpark figure, so you know you're striving for either $750,000 in retirement savings or $4 million.

Focus on what you can control; that is, stas.h.i.+ng away money automatically, keeping it diversified, and keeping your hands off it. The retirement goal might seem like an absurdly large number. But the only way to eat an elephant is one bite at a time.

1. Invest Automatically.

As discussed previously, making retirement contributions automatic is fundamentally important. Employer retirement plans are great because the money disappears from your paycheck before you get it. The other good way is to fund a retirement account with automatic monthly transfers from your checking account.

Here are some basic questions and answers about investing for retirement: * Why should I save for retirement? Because you'll reach an age where you don't want to work anymore, or physically (or mentally) can't. If you don't have savings earmarked for your retirement years, you'll be dest.i.tute or a burden to family members who will have to care for you.

* Why make it automatic? Retirement sounds like a long way off for many people. That makes it extremely difficult to make it a priority when the bustle of everyday life puts numerous demands on our money. With most people, if they have to write a check every month to their retirement plan, life will get in the way and they'll skip some months, or many months. But if you make it automatic, by contributing through a regular paycheck deduction or a regular draft from your checking account, you're more likely to succeed in saving regularly.

* Why invest at least 10 percent? Besides being a nice, round, easy-to-remember number, it's enough to start you on the path toward building retirement wealth. It also works well with the typical 401(k) plan, in which an employer matches the first 6 percent of whatever you contribute. You'll be guaranteed to capture all of that free money. And 10 percent is a good start toward 15 percent, a contribution goal many financial advisers suggest.

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One painless way to get to 15 percent is to raise your contributions by 1 percent or 2 percent every time you get a pay raise. That way, you won't notice a reduction in your take-home pay.

* Why use a retirement plan? You could just squirrel away money in regular mutual funds for retirement. But when you use the umbrella of a retirement plan, you can s.h.i.+eld the money from taxes, either now or later. If you pay less tax, you'll have more money in retirement.

* Which retirement savings vehicle should I use? This is where many people get bogged down. First, know that it's less important which retirement plan you choose. It's more important that you automatically contribute to a retirement plan-any retirement plan. That said, the following are brief descriptions of some of your choices: * 401(k) and 403(b). If you qualify for a 401(k) retirement plan at work that matches your contributions, join the plan and contribute 10 percent of your income. This is the easiest solution. The 403(b) and 457 plans are similar. These plans have such complicated-looking names because they refer to part of the federal tax code. Considering it involves the IRS, what else would it be except complicated?

A 401(k) allows retirement money to grow tax free. The pain of contributing is reduced because less tax money will be deducted from your paycheck. So, contributing $100 to your 401(k) reduces your net pay by less than $100. The exact amount depends on your income-tax bracket and several other factors. With a 401(k), Uncle Sam gets his cut when you withdraw the money in retirement. It will be taxed at your regular income tax rate, whatever it is at that time.

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If your employer matches your contributions, don't miss out on that free money! I've alluded to this previously, but it's worth emphasizing. Often an employer will contribute 3 percent of your pay if you contribute 6 percent. This is a fantastic deal. That's a 50 percent guaranteed return on your money. You can't get that anywhere else. Even if you dislike your employer plan, contribute at least enough to get the full matching contribution.

* Roth IRA. For those who don't have a 401(k) at work, open a Roth IRA and sign up to make regular contributions. With a Roth, you contribute money but get no up-front tax break. The benefit comes when you retire. That's when you can withdraw all the investment earnings contributed over the years, tax free. That's a huge advantage. The downsides are that higher-income people don't qualify to use a Roth and, if you do qualify, you can't stash away a ton of money-$5,000 a year in 2009 ($6,000 if you're age 50 or older). The earnings limits in 2009 were $120,000 if you're single and $176,000 if you're married. If your so-called "modified adjusted gross income," a line on your tax form, is larger than those limits, you can't use a Roth. And if your income is close to those limits, you might be allowed to make only a partial contribution of somewhat less than $5,000. Find updated limits and how to calculate modified adjusted gross income in IRS publication 590 at IRS.gov.

You can open a Roth IRA with many investment companies. Look for a place where you can make automatic contributions and one that has target-date retirement funds (more on that next, when we talk about diversifying your investments). You'll do well if you first check out Vanguard at www.vanguard.com, T. Rowe Price at www.troweprice.com, and Fidelity at www.fidelity.com.

Again, there are many ways to open a Roth IRA, including using a planner or broker and using a different family of mutual funds. But they probably will be more expensive because of broker commission and funds with high, built-in expenses.

* What if I'm self-employed? If you're self-employed, you probably have an accountant-or you should. Unless you'll make a hobby out of poring over income-tax strategies, taxes are often overly complicated for busy business owners. So, when it comes to investing for retirement, seek advice from your accountant. He or she will explain such retirement options as the individual 401(k), the SEP, and the SIMPLE IRA.

2. Diversify.

So, once you have decided on a retirement account and resolved to invest automatically, which individual investments should you choose? You've probably heard, "Don't put all your eggs in one basket." You might have heard of "diversification." They both mean the same thing-spread your money around to different types of investments. Good diversification has been shown to reduce volatility and improve investment returns over time.

Again, this is where people get bogged down and confused. So, here's some simple advice that will be more than "good enough" for most people: Put all your retirement money in a "target-date" fund closest to when you'll retire.

That's it, you're done.

"No way. It can't be that easy," you're thinking.

"Yes way. It can," I say.

Let's back up and talk about these "target-date" funds, sometimes called lifestyle funds. You've heard the phrase "the best thing since sliced bread?" Target-date retirement funds, at least the good ones, give sliced bread a run for its money. This is a one-stop-shop investment, a set-it-and-forget-it tool for retirement money, whether you're still working or already in retirement. Pick a year you'll probably retire, say 2030, and put all your retirement money into a 2030 target-date fund. Then you're on autopilot. Most employers nowadays offer these target-date options in 401(k) plans, and, of course, almost any mutual fund investment-including target-date funds-are an option in a self-directed retirement plan, such as an IRA or Roth IRA.

Everybody should know the basics of retirement planning, so following is the shortest primer on retirement allocations you'll ever see. But I contend that it suffices for most people.

* Spread your money around. Divvy up your money among major a.s.set cla.s.ses, typically U.S. stocks, foreign stocks, and bonds. Stocks, which refer to investing in private companies, are the higher-risk/higher-reward portion of your retirement bundle. Bonds are the safer portion. If one a.s.set cla.s.s grows quicker than the others, you have to "rebalance"-s.h.i.+ft money around in your investments-to get them back in line with your targeted allocations.

* Adjust your portfolio over time. When you're younger, you can afford to take more risk because you have time to wait out any prolonged downturn in the market. Therefore, portfolios for younger people have a greater portion of stocks and less of bonds. Conversely, as you approach retirement or after you retire, you can't afford to take as much risk because you'll need the money soon. That's why you want more bonds and less stocks.

That brings us to target-date funds. Target funds do both of those things-diversify and rebalance-automatically.

How do you choose a good target-date fund? If you're in an employer-sponsored retirement plan, you probably only have one brand of target-date funds, so go with it. If you're choosing among all investments-in an IRA or Roth IRA, for example-choose one from one of these three companies: * Vanguard, www.vanguard.com * T. Rowe Price, www.troweprice.com * Fidelity, www.fidelity.com Of course, other companies offer good target-date funds too, but I'm here to make things easier. And these three companies offer excellent choices in target-date funds.

If you want a nudge in a specific direction for opening a new account, check out Vanguard. It has the lowest built-in expenses, which is a good thing and arguably, over the long haul, the most important thing. If you have the minimum $3,000 to open an account, put all of it, including future contributions, in the Vanguard Target Retirement fund with a year closest to when you'll retire. It will have a name like Vanguard Target Retirement 2030.

QUICK TIP: TWEAKING TARGET-DATE FUNDS.

What if you want to take more risk than the average person with your retirement portfolio, or less risk? Simply choose a different target-date fund. If you want to take on more risk for the opportunity to get larger returns, choose a target-date fund with a date that's further away. It will have a higher portion in stocks. If you want less risk, choose a nearer target date. Don't know if you're a risk-taker? Take a quiz developed at Rutgers University, at http://njaes.rutgers.edu/money/riskquiz/. How freaked out did you get in 2008 when the stock market tanked? That's a very accurate measure of your risk tolerance.

What If Your Employer Doesn't Offer a Target-Date Fund?

If your 401(k) or other employer plan does not offer a target-date fund, retirement investing gets considerably more complicated. Get started by putting 60 percent in a broad stock index fund, such as a "total stock" index or "S&P 500" index. Put 20 percent in a foreign-stock index fund, and 20 percent in a bond index fund. But that's a generic and conservative allocation. You'll want to tweak that to fit your age and risk tolerance. One broad rule of thumb is to subtract your age from 120. That's the percentage of your retirement money that should be invested in stocks. The rest goes in bonds. So a 40-year-old would have 80 percent overall in stocks (60 percent U.S. stocks, 20 percent foreign) and 20 percent in bonds. If you're conservative, your stock-allocation percentage might be 100 minus your age.

You'll have to rebalance the allocations yourself, which again, refers to s.h.i.+fting money out of good-performing investments and putting the money into poorer performing ones. That's counterintuitive. But when you rebalance, you're essentially selling high and buying low, the most basic and best investing strategy. Rebalance at least once a year-on your birthday, for example-or when investment allocations get out of line by, say, 2 percent.

Why Index Funds?

An index mutual fund holds investments, such as stocks, that simply mimic an established index, such as the Standard & Poor's 500 Index. Index funds don't go searching for undervalued stocks ready to take off. In fact, index funds are dull and boring. And, oh yeah, they're superior to most funds you'll ever buy. Over time, index funds beat two-thirds to three-quarters of actively managed funds.

How can that be? It's because almost n.o.body, including the most brilliant minds on Wall Street, can consistently pick winning stocks over the long term. If some succeed over a short time, it's just as likely to be dumb luck as brilliance. Index funds are cheaper to operate because they don't have to pay for a big-salary stock picker. And they incur less tax costs because they trade less than actively managed funds. Therefore, more of the gains from the fund are pa.s.sed along to you, the investor.

If you're going to invest in mutual funds, whether inside a retirement account or outside, choose index funds. In fact, the target-date retirement funds I'm so fond of are the Vanguard ones. Why? You guessed it: It's a bundle of index funds.

This notion about index funds being superior to stock-picking funds is a fascinating topic. A famous book that lays out why it's true is A Random Walk Down Wall Street by Burton G. Malkiel.

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The amount of retirement contributions to put in your company stock should be zero percent, nada, nothing. You rely on this company for your income. That's plenty of your financial life tied to a single company. If you want to invest some "gambling" money in company stock, go for it. Another exception might be if a generous company match is doled out in company stock. But do not invest retirement money that you're counting on in company stock.

Already have retirement money in company stock? Sell it-gradually, if you prefer-and invest the money in a target-date fund or well-diversified portfolio of funds. Hope I wasn't unclear on this point.

3. Hold On.

Study after study shows that retirement investors are lousy at timing the financial markets, especially the stock market. They get out of the market when it's low and everybody is scared and discouraged. Then, they get in when the market is high and everybody is euphoric and optimistic.

Of course, their returns are far worse than they would have been if those investors just stayed the course. Keeping your money out of the market and missing just a few days of the best run-ups can have long-lasting effects-meaning you'll retire with significantly less money than if you had just held on.

Richard Thaler, the professor of behavioral science and economics at the University of Chicago whom I mentioned in the introduction, had this to say during one depressed period in the stock market: "I have not looked at any of my holdings and don't intend to. I don't want to be tempted to jump because I think I'd be more likely to jump in the wrong direction than the right one. My advice has always been to choose a sensible diversified portfolio and stop reading the financial pages. I recommend the sports section."

401(k) Rollovers.

It's a good idea to transfer money from the retirement plan of an old employer-or several old employers-into an IRA, where you have more investment choices, including target-date retirement funds. That involves some paperwork with your previous employer's human resources department and the fund company you'll use for your IRA. Again, Vanguard, T. Rowe Price, and Fidelity are good choices for IRAs because they are low-cost. It's important to use a direct transfer for the rollover money. The HR department will know how to do this. If the old employer sends you a check, you risk suffering a huge tax hit because the IRS will a.s.sume you withdrew all the money for nonretirement use.