Retirement Investing- A Comprehensive Guide

Infographic that explains why retirement investment planning is important, that you should start saving asap, that saving now for the long term can triple your contributions, how to calculate how much retirement income you will need, what things to consider when creating your long-term strategy, the different types of retirement plans available, and other things you should consider when investing for retirement.

Many people dream about what wonderful things they will be doing after retiring, such as traveling the world, golfing every day, or just relaxing and spending time with family and friends. For retirement dreams to become a reality, you need to have a retirement plan in place, and most people do not have one. It is crucial to start your plan for your future financial freedom and retirement investing as early as possible, so your money has time to grow.

These days, very few people have pensions anymore, and Social Security is certainly not enough to live a comfortable life after you stop working. So, it is up to you to have enough money put away to support yourself after retirement. Creating a retirement investing plan is not an easy task. It is a multistep process that evolves.

You will need to create a comprehensive financial plan by setting your financial goals and creating a timeline to reach those goals. You will need to estimate when you want to retire, where you want to retire, and how much money you will need during retirement, consider the types of retirement investing plans available, decide on your risk tolerance level and your portfolio’s asset allocation, and how often you want to tune up your retirement investing plan. Here are some tips on how you can start a successful retirement investing strategy.

Start Retirement Investing Early 

After finishing school and getting your first real paying job, it might seem like the right time to treat yourself to some things you could never afford before. A new car, maybe some expensive clothes, and maybe taking a few trips you have always dreamed about. At this point in your life, the last thing you are probably thinking about is retirement, let alone start saving for it. However, every year you put off retirement investing can have huge consequences on the type of lifestyle you can live at retirement. The earlier you start planning and saving for retirement, the better, and the smaller your monthly contributions need to be to reach your financial goal.

If you start retirement investing early, you can start small, and with a long time horizon, your return on investment (ROI) will significantly increase each year. The longer you delay your retirement investing strategy, the higher your monthly contribution needs to be to reach your financial retirement goal. The best day to start saving and investing for retirement is today!

Start investing part of your disposable income when you are young, preferable in your 20s, and your financial responsibilities are low. If you are employed and have an employer-based retirement savings plan such as a 401K, by all means, take advantage of it. This will help with pretax savings and will make your money grow faster. Apart from your employer-sponsored retirement investing account options, it is smart to also consider Individual Retirement Accounts (IRAs) at a young age.

How Much Retirement Income Do You Need?

Some people think that Social Security will provide them with most of their retirement income. However, that is not the case as Social Security was designed to replace only about 40% or less of an average worker’s income. Another common source of potential retirement income used to be pensions. Although most state and local government employees are eligible for a traditional pension plan, unfortunately, these days, the private sector is not offering their employees defined-benefit pensions anymore.

Most financial advisors will recommend that you will need about 80 percent of pre-retirement earnings to live comfortably. With Social Security only providing part of the 80 percent, this means that it is largely up to you to ensure that you have enough saved and invested in supporting a comfortable lifestyle after you retire.

The best way to get started on your retirement investing plan is by estimating how much income you will need each year to meet your retirement goals. At the same time, you will need to consider certain other factors that can affect your personal finances after retirement. These factors include the following:

Expected expenses: Rent, mortgage payments, the cost of children’s college education, and work-related expenses such as commuting costs are the biggest pre-retirement expenses. During your retirement, these costs will be lower or non-existent. However, new costs can arise after retirement, particularly an increase in healthcare costs and premiums.

You also have to consider the lifestyle you are planning on living after you stop working and the costs involved in living that lifestyle. For example, if you plan on traveling a lot, you will have to put that in your retirement budget. Also, keep in mind that you have more free time to spend money. More spending in the future requires additional savings today. If you understate your expenses, you can easily outlive your portfolio, and that will cause you major financial problems. Therefore, it is crucial to account for all expenses you are likely to face as a senior before creating your savings and retirement investing plan.

Longevity: With the advances in healthcare and medicine, people live longer than they ever have before. Especially, If you are living a healthy lifestyle and have good genes, you will need to ensure your savings will last during all of your retirement. With the right planning and effort, you can retire at 60+ and live into your 90s, which means 30+ years of blissful retirement. 

Inflation: While inflation is unavoidable, it will impact your future dollars’ purchasing power and your retirement investments. If your retirement income is fixed and stays the same for a considerable period of time, there is a possibility you will face challenges during your later years, and you might not have enough money to maintain your lifestyle if you do not account for inflation in your retirement investing plan.

Estimating how much money you need during retirement is not an easy task, and there is no one-size-fits-all solution to arrive at that magic number. Your income needs will depend on the lifestyle you are planning on living, whether you will be living alone or with your spouse, health, and many other factors.

Ideally, the best way to get started on your retirement investing plan is to save and invest enough to have at least 80% of your current income to maintain your current lifestyle at retirement.

The Power of Long-Term Investing and Compound Returns

When it comes to retirement investing, time is your ally. Every year, the money you invest has the opportunity to compound. Start retirement investing early, and you will be surprised at the results. The power of compounding by investing your money for the long term and reinvesting interest, dividends, and capital gains, is enormous. But even if you have put off saving for retirement for a little bit, it is never too late to start. Every day that you are saving and investing is a day your money is working for you. 

It is a good idea to play around with some numbers in different scenarios to develop a sense of how your investment might grow over time. Of course, it is impossible to know what the long-term return rate will be on your investments, making it hard to know how much to invest. When looking at the average annual return rate of the S&P 500, it shows that since its inception in 1957, it is around 10%. When considering inflation and being very conservative, an expected growth rate of 6% seems pretty reasonable.

Now look at the following scenario with a 6 % expected annual growth rate:

Infographic that shows the end balance when investing $5,000, $10,000, and $15,000 at an annual growth rate of 6%.

As you can see, the longer you let your money grow, the faster it will grow. Each additional year can make a big difference in the size of your nest egg. Even by extending the savings time frame by a few years, you can amass a significantly higher sum. In other words, the more you save, and the earlier you save it, the larger your investment returns will be in your retirement.

There are no guarantees when it comes to retirement investing returns. Although the 6% growth rate we used before is conservative, look at the numbers below to see what your end balance would be when returns are even lower and when returns are higher after investing $5,000/year after 10, 20, and 30 years at 4%, 7%, and 10% annual growth.

Infographic that shows the end balances of an investment of $5,000 per year for 10, 20, and 30 years at a growth rates of 4%, 7%, and 10%.

Please keep in mind that these numbers are based on the historical returns of the S&P 500. If you plan on investing primarily in CDs or bonds, your average returns will be significantly lower.

Things to Consider Before You Start Your Retirement Investing Strategy

Before considering which types of retirement plans and retirement investing options will be best for you, you should consider the following:

  • Existing high-interest debts: Do you have high credit debt or other high interest-bearing outstanding debts? If you do, pay them off immediately, as high-interest rates should always be avoided and paid off as soon as possible. Otherwise, you may end up paying off your credit card debt with the ROI from your retirement investments!
  • Existing emergency fund: Separating your emergency fund from your retirement fund is a must. This way, should you need any emergency liquid funds, you have the means to access them without penalties, without affecting your long-term investments.
  • Locked-in investments: When considering retirement investing, you will need to assume that your investments will be locked up/not accessible for at least 5 to 10 years, if not more. During this time, you should not touch your investments, even if the stock prices decline.
  • Retirement goal planning: If you have a partner, you should agree on your retirement goals and financial plans.

Types of Retirement Plans 

Based on whether you are employed, self-employed, or own a small business, or are an individual looking for a retirement account, there are usually several retirement investing account options to choose from. Each of them has different benefits and challenges. They include the following: 

Infographic that explains the different types of retirement plans divided into employer-sponsored plans, individual plans, and self-employed & small business plans.

Employer-sponsored retirement plans

  • 401k and other contribution plans: These are normally considered employer-sponsored defined contribution plans and are normally funded by employees. They provide an easy way for retirement investing and benefit from automatic payroll deductions, tax incentives, and even matching contributions. As for the company match, if your company offers a 401(k) and matches a portion of the money you contribute, contribute at least until you receive the full match. This is free money, so make sure you take advantage of it. 401(k)s are funded with pre-tax dollars, meaning you get a tax deduction for the contributions in the year you make them.  You also don’t have to pay taxes on the earnings from the investments, making your investments grow faster. Income tax is due only on the money you withdraw during retirement. There is a limit as to how much you can contribute to a 401k. The contribution limits in 2020 and 2021 are $19,500 for those under age 50 and $26,000 for those age 50 and above. Starting at age 72, you must withdraw some money from your 401k retirement plan every year and pay ordinary income taxes. You must take this Required Minimum Distribution (RMD) each year by December 31. Besides the traditional 401k, other contribution plans such as a Roth 401k. This plan is similar to the traditional 401k, but contributions are made after taxes. Another contribution plan is a 403b, which a tax-sheltered annuity plan for certain tax-exempt organizations. Then there is a 457b plan, a tax-favored retirement savings plan for state and local government employees.
  • Defined benefit plan/pension plan: Pension plans offer guaranteed retirement benefits for employees. They are largely funded by employers, with retirement payouts based on a set formula that considers an employee’s salary, age, and tenure. Defined benefit plans distribute their benefits through life annuities. Employees receive equal periodic benefit payments (monthly, quarterly, etc.) for the rest of their lives. The liability of the pension lies with the employer/sponsor who is responsible for making the decisions. In the U.S., most public employees are covered by a defined benefit pension plan. In contrast to a defined benefit plan, which covers only a small percentage of workers in the private sector.
  • Thrift Savings Plan (TSP): A Thrift Savings Plan is a defined contribution plan similar to a 401k but is only offered to federal employees and uniformed personnel. The TSP offers 6 investing options.

Individual retirement plans

  • Traditional IRA: A traditional IRA has similar tax incentives as a 401k. If you meet certain requirements, you can fund your account with pre-tax dollars. You also don’t have to pay taxes on the earnings from the investments. Income tax is due only when you withdraw the money during retirement. IRA’s can often save you lots of money in taxes. Any withdrawals you make in your retirement are taxed at your individual income tax rate at the time of your withdrawal. Your income is often lower during retirement than before retirement, resulting in a lower income tax bracket. Contribution limits are $6,000 as a combined IRA limit; $7,000 for those age 50 and above. Starting at age 72, you must take your Required Minimum Distribution (RMD) each year by December 31.
  • Roth IRA: Roth IRA contributions are not tax-deductible as they are after-tax contributions. However, the qualified distributions are tax-free, and contributions can be withdrawn at any time. Unlike most retirement accounts, this option doesn’t have any required minimum distribution until after the owner’s death.
  • Other types of IRAs: Spousal IRAs, myRAs, and rollover IRAs.

Retirement plans for self-employed and small business owners

  • SEP IRA (Simplified Employee Pension): This is a simple, tax-deferred retirement plan for anyone self-employed, owns a business, employs others, or earns freelance income. Employers and self-employed establish these IRAs. Employers can make tax-deductible contributions toward their eligible employees’ retirement and their own retirement savings. There are contribution limits for SEP IRAs. Employers are generally the sole contributors. However, employees may be able to make traditional contributions to the SEP-IRA.
  • Simple IRA (Savings Incentive Match PLan): This is a type of tax-deferred retirement savings plan that can be used by most small businesses with fewer than 100 employees to make contributions toward their eligible employees’ retirement and their own retirement savings. While employees can choose to contribute to the plan, employers must either make a fixed or a matching contribution.

Asset Allocation of Retirement Investments

Several variables can determine your ideal asset allocation when investing for retirement. The following guide will help you optimize your retirement investment allocation:

  1. Understanding the basic concept: To identify a retirement portfolio that offers you the ideal growth potential and risk exposure to match your needs, you will need to understand what asset allocation is. Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentages of different assets in an investment portfolio according to the investor’s risk tolerance, financial goals, and investment time frame. With this in mind, you have to understand the pros and cons of the different assets available for retirement investing. For example, individual stocks offer long-term growth potential but can be volatile over short term periods. Bonds, on the other hand, can help preserve your capital but offer limited return potential. Mutual funds offer great diversification and potentially high returns, but fees can be high as they are actively managed. Index Funds offer low risk, steady returns, and low fees. However, they offer little flexibility. ETFs (Exchange Traded Funds) are easy to trade and offer easy diversification, but fees can add up if the number of trades completed is high. Cash assets are also a risk-free option, but they earn minimal returns. Then, there are asset classes such as commodities, real estate, and other alternative investments. Before you start retirement investing, make sure you have educated yourself on the different asset classes and the risks and return potentials that each of these assets carries.
  2. Age-appropriate asset allocation mix: Your retirement investments should be earning much more than traditional savings accounts and money market accounts. The old rule of thumb used to be, to estimate the ideal asset allocation, you would take your current age and subtract it from 100. The result would be the percentage of your asset that should be allocated for investment options such as stocks, with the remainder invested in fixed income assets. However, many financial advisors now recommend that the rule be 110 or even 120 minus your age with people living longer because your money needs to last longer, and stocks can give you that extra growth boost.
  3. Evaluate your own risk tolerance: There is a chance that your portfolio value can drop by more than half at some point in time. That is why retirement investing should be a long term strategy as it reduces volatility over time. However, everyone has their own risk level they are comfortable at. Just remember that decreased risk often goes paired with lower returns.
  4. Choose your investments wisely: Stocks, bonds, and cash are the most common assets in a retirement portfolio, and these different asset classes can create a diversified portfolio. However, not all investments in the same asset class carry the same level of risk. Diversification within an asset class can also reduce your risk significantly. Within stocks, you should diversify by including small-cap, mid-cap, and large-cap stocks in your portfolio, as well as domestic and foreign stocks.
  5. Do your homework – review your investments regularly: Once you have your retirement investing plan in place, it is important to periodically review your investments to ensure they are still on track to meet your goals, especially when major life changes occur.

Pay Attention to Fees

All retirement investing options come with their own set of fees, which can drastically eat into the profits of your investments. The most common fees charged include:

  • Transaction fees
  • Expense ratios
  • Administrative fees
  • Loads

The fees can add up depending on the type of accounts you have and the type of investments you select. It is crucial to figure out how much you will be spending on fees before you start investing. If you are paying too much, you need to shop for other retirement investment options that offer reduced costs and lower fees.

Regular Tune-Ups for Your Retirement Investing Plan

Like a well-oiled car that needs regular tune-ups to function optimally, you also need to regularly tune up your retirement investment portfolio. Here are a few guiding factors that can help you get started:

Are you on track? The longer you live, the longer will you need your money to last. You will need to consider your current retirement savings, your age, income, and your estimated social security benefit. You will also need to consider additional factors or potential gaps that will indicate where you currently stand.

Has your risk tolerance changed? Your risk tolerance may have changed when you first started saving for retirement. However, as your retirement is getting closer, a more conservative approach might feel like a better fit.

Have you rebalanced your investments? Over time, your investments will perform differently. While some options, such as the 401(k) option offer automatic rebalancing, other retirement investing plans may not offer the same. You need to review your portfolio mix to meet your retirement investment goals. For example, your ideal asset allocation is set at 70% stocks and 30% bonds. However, in the last few years, your stocks have skyrocketed, and now your allocation is 85% and 15%, so it is time to sell some stock and buy some more bonds to rebalance your portfolio to stay on track.

Consolidate your retirement investment accounts? Over time, you may have accumulated several different retirement accounts. Not only can having multiple accounts be overwhelming, but it may also make it difficult to gauge if you are on track to meet your retirement investing goals. By combining your accounts, you can help simplify the process and help progress towards your goal.

Conclusion

Retirement planning and investing are crucial to meet your retirement goals and possibly financial freedom after you stop working. However, your plans can be influenced by many different factors, such as market conditions, employment, age, income, and even your emotions. For example, if your investments perform well, it can lead to overconfidence, underestimating risks, and lead to bad decisions resulting in loss of investments. On the other hand, these factors can also induce fear and lead you to invest in low-risk options that will not benefit from a market recovery. To balance risk and returns to meet your financial goals, you should:

  • Start planning and investing for retirement as early as possible
  • Understand your available options
  • Be realistic and keep your emotions in check
  • Maintain a balanced portfolio
  • Be in it for the long term
  • Get help from a financial advisor if needed

Successful retirement investing requires you to stick to the plan, in good times and in bad. Remember that a single wrong decision in a volatile market can take years to recover from.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.