It’s early in 2013. Stocks had a terrific year in 2012, the fiscal cliff has been avoided—and so now’s the perfect time to reconsider your retirement plan, right?
Well, yes and no. Yes, tax time is a good time to reevaluate financial plans and in particular focus on your retirement program. But, no, it’s rarely the case that a retirement plan needs to be completely reworked just because of a good year in the stock market or changes in tax rates. A successful retirement plan is built over decades, not in reaction to short-term news, and depends on a consistent pattern of saving and investing.
Savings rates. For those of you still working, the first-order retirement problem is how much to save. Investment and tax issues are complex and fascinating—and often a distraction, since they won’t make up for poor or inconsistent savings habits.
Our rule of thumb at Vanguard is to save 12%–15% of your income, usually in a tax-deferred retirement plan at work. Since most employers chip in a matching contribution of at least 3%, consider a goal of contributing at least 10% of your own pay to an account.
This goal will vary with your age, income, how much you’ve saved in the past, and any pension benefits you expect to earn. Younger investors starting out in their careers can begin at a lower level. I recommend that twenty-somethings new to the workforce consider saving at least 6% of pay for two reasons. First, to start the discipline of saving, and second, to capture the most common type of employer match at work. If you’re in your 30s and 40s and not saving at a 10% clip, you should think about moving to that level: One way to do this would be to boost your paycheck contribution rate by 2% each year until you’re contributing 10%. If you’re a six-figure-earner, consider setting a higher target north of 15%, if not 20%.
For those age 50 and older, some extra work is required. Undertake a tailored savings calculation once a year (tax time is the perfect opportunity). Use a calculator like Vanguard’s or check out some of the new web apps. I just used the Smart Money app on my iPad and liked it.
Withdrawal rates. For those in retirement, the flip side of saving for retirement is spending down assets. Your task is to estimate how much income you can expect to receive from your retirement savings and investments. The simple rule of thumb is that a 4% withdrawal rate from assets (invested in a balanced portfolio of stocks and bonds) beginning at age 65 is a good starting point for how much you can spend. But, again, this has to be customized to a number of personal factors. If you’re older, this fraction can be higher. If you’ve spent more in the past, you’ll need to consider trimming the amount you can spend this year. If you have a pension or other income sources, you may need much less.
Many of today’s retirees tend to limit their withdrawals from what interest or dividends they receive on taxable accounts (which today are usually much less than 4%) or from required minimum distributions from IRAs and employer plans after age 70 ½ (which can often be above 4%). A better approach is to think about income as a spending policy against a portfolio—and to spend not just income and dividends but also capital gains and sometimes principal over time. A recent blog I posted spends more time on this issue.
Portfolio choices. I remain surprised at how many investors don’t regularly complete a simple calculation of their portfolio allocation. Simply add up all of your savings and investment holdings—including all taxable and tax-deferred accounts, as well as investment real estate or other assets—and determine what fraction is invested in stocks, bonds, and cash. You can also include personal investment real estate and other assets if applicable. In particular, the fraction you have in stocks is the top-line measure of the level of risk you’re assuming.
Assuming you’ve done the calculation, how can you evaluate where you stand? One benchmark is the investment approach underlying Vanguard Target Retirement Funds. Stock percentages are at 90% or so for individuals through their 40s, and then gradually decline to 50% by age 65—falling further to 35% by age 72. Another more individualized approach is to complete our risk questionnaire. If the large rise in the stock market in 2012 means you’re overweighted in stocks, it’s time to consider shifting some money to bonds or cash investments (preferably in a tax-deferred account to avoid a current tax bill). Or vice versa, if you feel you’re underweight in your risk exposure.
Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the Fund name refers to the approximate year (the target date) when an investor in the Fund would retire and leave the work force. The Fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in the Target Retirement Fund is not guaranteed at any time, including on or after the target date.
It turns out that most investment news day-to-day is not about issues like aggregate risk exposure, but about specific diversification strategies. Should I have more or less money in bonds? In REITs? What about emerging markets? Small-cap? What about sector funds? Corporate or high-yield bonds? And so on.
While all of these individual diversification strategies have their advocates, one potential strategy (which we believe in at Vanguard) is to construct the bulk of a portfolio with broadly diversified equity and fixed income funds, such as low-cost index options. Then, if you have the time and energy, and this fits your overall goals and tolerance to risk, it could be worth considering allocating a small fraction of your portfolio (usually less than 20% or 25%) to specialized strategies. But even as you do this, it’s essential to keep your eye on your total equity risk exposure.
Taxes. The recent tax law changes offer up an additional tax-planning opportunity for retirement in 2013—an expanded ability to convert pre-tax 401(k) savings to Roth savings. I’ll be back with another blog on this topic soon.
Notes: All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss. Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments. This post is should not be considered to be advice, and investors should consider their own personal circumstances before making any decisions.