When it comes to retirement savings, many people feel overwhelmed. They know they want to live the good life in their golden years, and know they should save as much money as possible, but beyond that, many are just clueless. They need some guidelines, a place to begin.
Here are seven rules for making retirement decisions that can be a starting point for your retirement planning.
1. Start with a comprehensive financial plan
Identify your mission, vision, values and goals. “How do you know if you are investing the way you should? Through the development of a plan your goals will become clear. Investment strategies should support and compliment what it is that is important for you and your family,” says Leonard Wright, wealth advisor, Northwestern Mutual Wealth Management Company.
Make sure though, that your planning includes the possibility of spending some number of years in a nursing home. “This will help you be prepared, and also help you assess if you should buy insurance or simply pay the cost of long term care from income and assets. Keep in mind whether there might be an inheritance that could be set aside to pay for nursing home care, or if you would downsize your home during your later years to come up with money for long term care,” says John Hauserman, author, RetirementQuest: Make Better Decisions.
What resources, such as Social Security and pensions will you have? Say you think you'll need income of about $80,000. “Let's say you have a pension of $20,000 and projected Social Security at the age you want to retire that both have cost-of-living adjustments. You would then need to solve for $40,000 worth of income from your retirement investments. If you don't have a cost-of-living adjustment the calculation is a bit harder because you have to make up for the lack of increase from your retirement investments,” says James Brewer, a financial advisor with Envision 401k Architects.
Figure out how much you will need in investments in retirement to supplement other sources of retirement income. You need to know how much to invest each year and what investment return you will need on those investments from now until retirement, as well as during retirement. “Without knowing where you need to be, it is impossible to know how to get there,” says Jim Oliver, a CPA with Jim Oliver & Associates.
2. Know your core financial priorities
What is the primary focus of your money – growth, income, liquidity or preservation? Rank these priorities in order of importance where number one is your top financial priority and four is the lowest. While all these are important, one is always more important. For most people in retirement, making sure they have enough income to last their lifetime is usually number one. “Once you know your priorities, make your overall financial decisions based on your priorities only,” says Steve Lewit, CEO of Wealth Financial Group.
3. Understand your asset allocation between risk and safe money
Diversity is key. Research shows that asset allocation explains 91% of the growth of a portfolio (market timing, picking the right stocks, etc. is the balance of 9%), says Lewit. The first step in asset allocation is to determine the amount of your assets you want at risk to market forces, and the amount you want guaranteed and the amount you cannot lose, he says.
Set your mix of stocks, bonds, and short-term investments based on your time horizon. To determine the percentage of your portfolio to hold in stocks, a good rule of thumb is to subtract your age from 110, then multiply the result by 1.25 says Stuart Ritter, a senior financial planner with T. Rowe Price. In other words, your asset allocation should match your goals, says Ritter. Shift from stocks to bonds and cash as your time horizon shortens, rebalancing your portfolio's asset allocation and diversification to your new target at least once a year, he says.
Be clear about your risk tolerance. “If you take more risk than you can tolerate to get investment returns, you will likely not stay invested consistently for the long term. Getting off the highway to your destination frequently will slow the time it takes to get there,” says Oliver.
4. Remove emotions from the equation
Take emotions out of decisions by always referring back to real data, or using an investment philosophy that is not based on market timing or picking winners. Research shows that these tactics never work over a sustained period of time anyway, says Lewit. While your investing plan is not etched in stone, do not veer from it frivolously.
5. Keep taxes in mind
Match the right investments to the right investment accounts. Investment types with advantageous tax treatment, such as small cap growth, should be in taxable accounts to take advantage of lower capital grains and the ability to choose when to pay taxes on those gains, points out Oliver. Investments with higher immediate taxability, like high yield corporate bonds, should be in qualified retirement and IRA accounts to postpone the taxes until withdrawal, while Roth accounts are the place where investments have a potential immediate tax bite, but also a potential for substantial increase in value due to inflation, such as treasury inflation protected securities (TIPS), commodities or real estate for example, explains Oliver. “Smart tax placement of investments can increase your overall return.”
6. Is the decision based on the past or the future?
Very few investments that were top performers last year will repeat as such in the coming years, says Jason Laux, vice president of Synergy Financial Services. “Be cautious that retirement investment decisions are not solely based on past performance. Do not let choices made in the past cloud your future vision. A bad or good experience with a past investment can be overweighted when making a current decision. New markets require new thinking and sometimes that means revisiting an older failed option or disregarding a past success that would no longer be appropriate,” he says.
7. Control investment expenses
Avoid high cost annuity products, mutual funds or investment managers. Be clear on all costs and fees associated with the investment. “These costs are a drag on profits, particularly over decades,” says Tiffany Washington of Washington Accounting Services.
Ask yourself whether you can afford the investment. Whether the investment is a vacation home, classic car or a market-based investment that carries principal risk, understand what the decrease in liquid capital or potential market loss may do to your future ability to live comfortably, says Laux.