Goals for Retirement
There are two cardinal rules to remember about saving for retirement:
- The money you put in a retirement fund is tax-free, so it reduces your tax burden. You only pay taxes on it when you withdraw it at retirement (although you can also withdraw it early for certain hardships).
- The earlier you contribute to your retirement plan, even if it is a small amount, the richer you will be at retirement due to the magic of compound interest.
Your retirement goals may be slightly different from mine but probably not too much. Personally, I would like to be completely out of debt and maintain approximately the lifestyle I have now. Unfortunately, Social Security, as wonderful a program as it is, will not accomplish that. As I will explain a little later, Social Security is just a safety net that will not support you in the style to which you are accustomed. Social Security benefits are much more modest than many people realize; the average Social Security retirement benefit in June 2019 was about $1,470 a month, or about $17,640 a year. If you retire at the full retirement age (which is now 67) the maximum you can receive in monthly Social Security Benefits is $3,011, if you have earned a good salary and paid in your 6.25% Social Security Tax each month (as a payroll deduction). This is only $36,132 per year, and it is subject to income tax deductions. You can earn a bit more if you delay receiving SS benefits until the age of 70, but generally, the economics are better to start receiving them at 67, even if you are still working.
In a recent survey, close to 50% of people 18 years and older report that they have no retirement savings—a national tragedy! We have to assume this means retirement savings other than Social Security, because if you are working, the 6.25% Social Security Payroll Tax is deducted from your payroll by your employer and sent to the IRS.
A good goal for retirement is to have enough income to match 70% of your pre-retirement disposable income. You will likely have your mortgage paid off and will not have any work-related expenses such as transportation, so 70% is a reasonable goal to achieve. I have read some recent articles that say 60% of pre-retirement income is adequate based on lower expenses. However, I am not ready to advocate that. In any case, these instruments can help you save up to 70% of your pre-retirement income:
- Social Security Payments
- Personal Savings
- 401(k)s or 403(b)s
- Individual Retirement Accounts (“IRAs”)
- Roth Individual Retirement Accounts (“Roth IRAs”)
- Annuities
Social Security Payments
The Social Security Act, part of FDR’s New Deal, was passed August 14, 1935 in the midst of the Great Depression. It was founded as an insurance program administered by the government that would act as a safety net for retirees. Every pay period, an employee pays 6.2% of their earnings for Social Security and 1.45% for Medicare taxes. Workers pay the 6.2% Social Security tax on annual earnings up to $137,700. Meanwhile, the employer pays the same rate per paycheck, adding up to a combined 12.4% Social Security tax and 2.9% Medicare tax. You can collect your full Social Security benefits at age 67, and they are not taxed if you are over 67. You can also delay receiving your benefits until age 70 and receive higher benefits at that time. However, it generally does not make economic sense to defer your benefits. Once you become 67 and start collecting your benefits, you can continue to work, and it will not affect your benefits. You can also begin collecting at 62 with reduced benefits and further benefit reductions if you earn a certain amount of work income. Social Security is an insurance program that you and your employer paid for; it is not welfare.
The maximum monthly Social Security benefit that an individual can receive per month in 2020 is $3,790 for someone who files at age 70. For someone at full retirement age, the maximum amount is $3,011, and for someone aged 62, the maximum amount is $2,265. The benefit is calculated on your average wages, your salary, and the number of years you worked. The formula assumes 35 years of working life. However, the average Social Security Benefit in the U.S. for 2020 is $1,503.00. Even though it is increased every year according to the Consumer Price Index and not taxed if you are 67 or older, this is only $18,036.00 per year. As I said, Social Security is only a safety net. You will need your retirement plan and other savings to have a comfortable retirement.
401(k)s and 403(b)s
Many Baby Boomers (born in the years immediately following World War II) are now collecting defined benefit pensions. Defined benefit pensions will pay you a fixed pension benefit every month based on how much you earned and how many years you worked at the company. Often, this was 60% to 80% of your last salary before retirement. Companies had to put cash for these benefits in trust. However, if these investments lost money, the company had to come up with the payments to the retirees. There were also numerous underfunded pension funds that defrauded employees. Today, very few organizations have defined benefit pensions for their employees. Only 16% of the Fortune 500 public companies still have defined benefit pension plans. The other major organizations that still having defined benefit pension plans are the military, and federal, state, and local governments.
For most organizations with retirement plans today, they offer their employees what are known as defined contribution retirement plans. Defined contribution (DC) retirement plans are the centerpiece of the private-sector retirement system in the United States. According to a recent report from Vanguard, more than 100 million Americans are covered by DC plan accounts, with assets now in excess of $8.8 trillion. The vast majority are 401(k) plans. A 401(k) plan is a defined contribution plan set up by firms for their employees. Typically, the employee contributes an amount each month and the employer matches some or all of the employee’s contribution. A typical arrangement is for the employee to contribute up to 6% of their gross salary and the employer to match $.50 for each dollar the employee contributes. Vanguard also reports these statistics on the millions of retirement accounts they manage:
- 71% of Vanguard managed plans contribute $0.50 for each dollar the employee contributes up to 6% of salary.
- 22% of Vanguard managed plans contribute $1.00 for each dollar the employee contributes up to 3% of salary and $0.50 for each dollar the employee contributes for the next 3% of salary.
- 6% of plans cap their contribution at $2,000.
The huge advantage of a 401(k) is that both your contribution and the employer’s contribution is tax free. The money is typically managed by a bank or mutual fund; all income from your investments is tax free. You are only taxed on the money you take out every year upon retirement. (Of course, you must begin taking distributions no earlier than at 59 ½ years and no later than 72. The IRS gets its taxes eventually). In 2020, an employee can contribute up to $19,500 to a 401(k) tax free, no matter how much their employer matches.
Non-profit organizations can set up defined contribution plans called 403(b)s. The rules and regulations are almost identical to those of 401(k)s. The most important rule for you as an employee who is eligible for a 401(k) plan is to always contribute the amount matched by the employer. The employer’s match is free money and it is tax-deferred until you retire.
Individual Retirement Accounts (IRAs) and Roth IRAs
Whether or not you have a 401(k) or a 403(b) retirement plan, you can also set up an IRA and contribute money to it. The limit on annual contributions to an IRA in 2020 is $6,000. If you make less than $63,000 per year as an individual, you receive a tax deduction for your contribution. As with a 401(k), you pay no taxes on the IRA or its investment returns until you retire.
A Roth IRA is an alternative to the traditional IRA. The money you put into a Roth IRA is taxed as regular income when you contribute it. Actually, since it probably comes from your paycheck, you already paid taxes on it. However, the investment returns are not taxed and the withdrawals (after age 59) are not taxed (unlike withdrawals from 401(k)s and 403(b)s. The logic behind setting up a Roth IRA instead of a regular IRA has to do with your perception of where tax rates will be in the future. If you think income tax rates years from now will be more than income tax rates now, then you would set up a Roth IRA. Finally, Roth IRAs are not allowed for people whose income is above certain limits.
Do not let all of this taxation rate talk confuse you. The fact remains that the IRS will tax you now or tax you later. For the 401(k) and 403(b), you are not taxed on the money now but are taxed on it when you withdraw it. For Roth IRAs you are taxed on the money now but not when you withdraw it.
Finally, there are certain IRS rules on required withdrawals at age 70 or 72 from 401(k)s. 403(b)s, and IRAs. This assures that the IRS gets their share if you have not yet paid taxes on it. You should get the advice of your tax accountant on IRAs. However, generally for a young person a regular IRA makes better financial sense than a Roth IRA.
Annuities
An annuity is a retirement vehicle that is a contract with an insurance company or financial institution that provides annual payments for a specified number of years or until your death. Annuities are not substitutes for retirement plans. First, the money you contribute to buy the annuity is not tax deductible. Secondly, even though you are not taxed on the investment income from the annuity until you withdraw it, this does not compare favorably with 401(k)s, 403(b)s, IRAs or Roth IRAs. Next, the financial institution that manages your annuity usually charges high fees. Finally, the average return on an annuity is 3.27%, well below a retirement plan invested in the stock market, so it is best to discuss your retirement options with your accountant.
Companies to Handle Your 401(k)s or IRAs
There are many good companies to manage your money. However, if you are in an employer-sponsored 401(k) or 403(b) plan, your employer will have two or more companies already selected from which you can choose. There are for-profit mutual fund companies that manage funds for investors and manage retirement accounts for companies and their employees The largest U.S. for-profit mutual fund companies are BlackRock, Charles Schwab Company, and Fidelity Investments.
There are also nonprofits that manage funds for investors and manage retirement accounts for companies and their employees. The largest nonprofit mutual funds in the U.S. are Vanguard and TIAA. I recommend that you use Vanguard. Currently, Vanguard manages $5.6 trillion in assets and is a very low-cost mutual fund, due to the fact that they are a non-profit. Vanguard’s average mutual fund expense ratio is 0.10%, whereas the industry average is 0.63%. Their philosophy is based on research that shows no mutual fund has beaten the stock market index averages for more than two years in a row, and it is impossible to guess which will be the one to beat the S&P 500 each year. Jack Bogle, Vanguard’s founder, began offering index funds to customers and charging fees way below industry average. Vanguard has since expanded into many other mutual funds in various sectors. For more, look back to the previous chapters on investing.
Each year, Vanguard reports data on all their investors in How America Saves. The report notes that in 2019, the average account balance in Vanguard Retirement Accounts was $106,478. In 2019, 73% of retirement funds were allocated to stocks and the rest to bonds, cash, and other funds. There is no need to look at all the tables of asset allocation by age, but I think the contrast between the asset allocation of 25- and 65-year-olds is interesting:
Table 15.1. Asset Allocation by Age
| Age |
Stocks |
Bonds |
Cash |
Other |
| 25 to 35 |
87% |
2% |
1% |
10% |
| 65+ |
48% |
10% |
17% |
28% |
But which mutual fund should you invest your retirement fund in? The traditional, conservative money manager would advise you invest in a mutual fund that is composed of either 60% stocks and 40% bonds or 70% stocks and 30% bonds. Stock prices rise in economic expansions and bond prices tend to fall, while stock prices fall in recessions and bond prices tend to rise. Thus, whatever the economic conditions, your portfolio can achieve some balanced stability. Here are the returns on these conservative portfolios as reported by Vanguard at the end of 2019:
Table 15.2. Rates of Return on Defined Contribution Plans
| |
60/40 Balanced* |
70/30 Balanced* |
S&P 500 |
FTSE Global All Cap Except US |
| 1 year |
20.8% |
22.8% |
31.5% |
21.7% |
| 3 years |
10.0% |
10.9% |
15.3% |
9.8% |
| 5 years |
7.6% |
8.3% |
11.7% |
6.1% |
Source: Vanguard
I do not recommend either a 60/40 portfolio or a 70/30 portfolio for your retirement funds. I explain this in more detail in the chapters on investing. However, for a simple reason, look at the returns of the benchmark S&P 500 above compared to the 60/40 and 70/30 balanced funds. My recommendation is to invest your retirement funds in an S&P 500 mutual fund. This fund has all the S&P 500 stocks in it and will achieve the in S&P 500 Index increases. According to historical records, the average annual return since its inception in 1926 through 2018 is approximately 10%-11%.
I also do not agree with the conventional wisdom that you should decrease the share of stocks and increase the share of bonds in your portfolio as you get closer to actual retirement. The traditional advisor will say that your share of bonds should be related to your age. For example, when you are young, invest your retirement fund in a 60/40 mutual fund. When you turn 50, change your allocation to 50/50. At 60, change your allocation to 40/60.
Several mutual fund companies even offer what are known as Target Date Funds, which automatically increase over time the share of bonds versus stocks in an individual’s retirement fund once they pass the age of 50. The traditional advice makes no sense to me, given that the average return on the S&P 500 over the historical record (10%) is double the average return on bonds (5%). I am not the only advisor who feels this way.
In my opinion, you should keep all your retirement savings in an S&P mutual fund, until you are two years from retirement. Then each year make sure you move two years of your estimated expenses in retirement to a bond fund and continue to have two years in a bond fund every year of retirement. That way you will continue to achieve double the returns in retirement while protecting yourself from having to sell stocks in a down market to pay for retirement expenses.
Rolling Over Your Retirement Funds
Your 401(k)s, 403(b)s, and IRAs are portable; you can take them when you leave an employer. The funds you contribute always belong to you; however, the employer’s contribution often has some vesting period (often three years) until the employer’s funds belong to you. You can leave the funds in your current mutual fund manager or transfer them to the mutual fund manager at your new employer. Just make sure you have the funds transferred from manager to manager and not sent to you. The mutual fund managers are quite familiar with how to accomplish this.
Imagining Your Retirement
I know it seems quite early to think about what you will be doing in retirement, but it is certainly important to spend a little time doing so. Karl Marx said, “Man is a worker”; we want to do stuff. It is important to develop hobbies or volunteer work you will like to do in retirement. It will keep you physically and mentally active, and more importantly, it will put you in contact with other people. Loneliness will shorten your life. An active and interpersonal retirement will help you live a long and happy life.
