Preparing For Retirement in an Uncertain Economic Climate
In the aftermath of extreme stock market volatility, corporate accounting scandals, and decreasing 401(k) account balances, many people are wondering if they will ever be able to retire. Below are six thoughts to consider and to put current economic events into perspective:
The stock market is very volatile in short time periods, but has historically outperformed bonds and cash assets, especially in long time periods of ten or more years. Investment volatility is also reduced over long time frames, a principle known as time diversification. Remember that your investment time horizon is the rest of your life...not your retirement date. This means that if you are 45 years today and live to age 85, you have 40 years for your money to grow through the power of compound interest. Your assets should be invested aggressively enough to offset the effects of taxes and inflation. This means considering some stock or growth funds in your portfolio.
To avoid the problem of investing in companies that are later found to have "accounting irregularities," investors can select broadly diversified actively managed mutual funds or index funds that track market indices. To reduce portfolio volatility, avoid aggressive growth funds, sector funds that include only one industry (e.g., technology), and concentrated or "focus" funds that have only a small number of stocks in their portfolio. Instead, consider mutual funds that contain more than one type of asset and, therefore, have less investment risk, such as balanced funds, asset allocation funds, and equity-income funds. A good source of information about mutual funds is Morningstar, a reference tool in libraries and online at www.morningstar.com.
Reduce investment risk by not concentrating your portfolio in any one company or industry. Periodically compute the percentage of your investments in individual companies and industries. Many financial experts recommend not investing more than 5% of assets in any one company (including an employer) and no more than 10% in any one industry (e.g., telecommunications).
2001 tax law changes provide increased opportunities to make up for lost time and money. If you are 50 and over, starting in 2002, you can contribute additional catch-up amounts to both an Individual Retirement Account (IRA) and a tax-deferred 401(k), 403(b) or 457 deferred compensation plan. Another beneficial tax law change is that there is no longer a limit of 25% of gross income when funding a tax-deferred plan. Low-income workers who can afford it (e.g., those with another major earner in their household) can contribute 100% of their earnings up to the maximum limit allowed annually.
A person's choice of retirement housing can greatly affect the amount needed to save for retirement. Trading down to a smaller home, say from a $200,000 home to a $100,000 condo, can be a very effective catch-up strategy. Proceeds from the sale, minus sales and moving expenses and the cost of a new home, are available to invest for income. Property taxes, utilities, and maintenance may also be lower. Another way to reduce retirement living costs is to move to a less expensive location.
Continuing to work, even just a few years longer- provides additional income to invest in tax-deferred plans. It also postpones asset withdrawals, which is especially beneficial during market downturns because it allows account balances to rebound with compound interest. In addition, workers in defined benefit pension plans may be able to increase their benefits by remaining on the job longer. Social Security benefits may also increase. If, for example, you plan to retire at 62, you must begin--at age 45--saving $13,469 per year to afford $20,000 annual withdrawals at retirement. If you wait until age 68 to retire, you would only have to save $7,701 per year, or a difference of saving $5,768 per year. This analysis assumes 3.5% inflation, an 8.5% average annual return, and average life expectancy based on U.S. Census Bureau data.