by Suze Orman
Now, if you happen to have a big pile of cash ready to contribute to an IRA, that’s great. But what’s more likely is that contributing smaller sums throughout the year will be more practical. Here’s what you would want to save on a monthly or quarterly basis to reach the maximum annual IRA contribution limit:
IRA PERIODIC INVESTMENT TABLE
If you are 49 or younger
MONTHLY CONTRIBUTION TO MEET ANNUAL MAXIMUM* QUARTERLY CONTRIBUTION TO MEET ANNUAL MAXIMUM*
$416.65 $1,250
*In 2011 the maximum annual contribution limit is $5,000 for individuals below age 50.
The best way to do this is to set up an automatic investment system that pulls money out of your checking account each month and invests it in your Roth IRA. Do not leave this to your own best intentions; even if you vow you will make monthly contributions it can be hard to stick with a plan, especially when unexpected expenses pop up. It’s best to make this an automatic system that takes you out of the equation. The discount brokerage or fund firm you choose for your IRA will have an easy form for you to fill out that authorizes a monthly (or quarterly) transfer from a bank account to your IRA.
Where to Open an IRA Account
I recommend you use a reputable discount brokerage firm such as TD Ameritrade, Fidelity, Schwab, ING, Muriel Siebert, Scott-trade, or Vanguard. I prefer discount brokerages or no-load mutual fund companies because of their low (or no) trading costs, low account fees, and low-expense mutual funds and ETFs. Banks and insurance companies that offer IRA accounts typically charge higher fees. I’d prefer you keep every penny you can invested for retirement, rather than allow any to go toward paying fees. For that reason, discount brokerages or the mutual fund company itself are your best options. Under no circumstances would I open a Roth at a bank, credit union, or insurance company.
STEP 3. Increase Your 401(k) Contributions
If you max out on your Roth IRA contribution and you still aren’t at your 15% savings goal, then you are to increase your 401(k) contribution (match or not) to get you to 15%.
STEP 4. Save in a Taxable Account
If you don’t have a 401(k) and you have maxed out on your IRA for the year, you can keep saving more in a regular taxable account. A great strategy is to create a portfolio of a few ETFs. Unlike mutual funds, there typically is no annual tax bill with ETFs; the only time taxes are owed is when you sell your shares at a gain. That’s a great way to invest for your long-term retirement goals.
That’s it—four steps.
LESSON 4. INVESTING YOUR RETIREMENT MONEY
Making the commitment to contribute to a 401(k) and an IRA is just half the job. You must also take responsibility for choosing the investments you own inside these accounts—yet another task prior generations didn’t have to stress over.
Based on the countless questions I get about this subject, it’s clear to me that many of you are totally confused about how to allocate the funds in your accounts. When I ask you how your retirement money is invested you typically tell me you have a 401(k) or an IRA. I then ask again, “Yes, but how is your retirement money invested?” and you look at me like I am nuts because you just told me you had a 401(k) or an IRA.
Please understand that a 401(k) and an IRA are simply retirement accounts that hold your investments. You must choose what investments to put inside your accounts. If you don’t make that choice, your 401(k) or the brokerage firm that handles your 401(k) will often just leave your money in a cash account. Another common scenario I see is that you try to invest the money in your accounts but you get overwhelmed and panic and you decide that cash is the best option.
And I know that some of you aren’t investing because you have no faith that investing is the way to go, period. You were spooked by the volatility of the stock market in 2008. The investing community is well aware of exactly how you feel. The CEO of one of the largest mutual fund companies has publicly laid it out that the financial services industry is on the verge of losing an entire generation of investors—young adults like you—who have experienced a whole lot of bear market pain without any offsetting bull market upside to temper your nerves and perspective. In a recent survey of investor attitude toward risk, the biggest drop in a willingness to take investment risk was among the youngest investors—those below the age of 35.
That makes complete sense. No one, not even financial industry honchos, would fault you for feeling that way given what you have lived through. But I am going to ask you to summon all your stand-in-the-truth strength and fight through those feelings. I am not asking you to forget those feelings, nor am I suggesting you are wrong for feeling hesitant to invest in stocks.
But here’s where we need to think through what your dream is: retirement. You are not retiring next year, or next decade. It’s a dream that is 30, 40, maybe even 50 years off. Yes, I am going to hit you with another riff on the power of time.
The first time-sensitive issue I need you to grasp is that by playing it safe today and keeping all your money in bonds and cash you will miss out on the opportunity to earn returns that exceed the inflation rate. And make no mistake, you must focus on earning inflation-beating gains. It’s simple: If your savings do not increase enough to counteract inflation you will not be able to maintain your standard of living in retirement. So I am here to tell you that you must consider investing a portion of your portfolio in stocks.
Just as a guidepost, keep in mind that the long-term average rate of inflation is about 3.5%. So at a minimum you want your investments to be earning at least that much, preferably more. If you are invested in the most conservative option in your company 401(k)—it can be a money market fund or a stable-value fund—you are not earning more than 1%, if that, right now. Yes, a money market or stable-value fund is “safe” in that its value will not go down, but when you are investing for a goal that is decades away you must also think about the risk of your money’s purchasing power not keeping up with inflation.
UNDERSTANDING THE UPS AND DOWNS OF THE STOCK MARKET
The truth is, right now is an absolutely fabulous time to be investing if you won’t need that money for decades. None of us can predict with 100% accuracy what is going to happen in the stock market over the next few years, or even the next few months. But when you are investing in a retirement account that you will not use for decades, you shouldn’t be focused on what happens right now. To be totally honest, you should look at any market drop as a good investing opportunity.
Now why do I say that? Because when the market goes down you can buy stocks on sale. If you needed that money in a few months or a few years there would be the risk that the price might be even lower. But that’s not what we are dealing with here. You have two, three, or four decades until you retire and then you could live another 25 years in retirement. So you shouldn’t really care what happens to the stock over the next few years. What you want to stay focused on is the long term and the long-term trend is that stock values rise. Therefore you absolutely want to have some of your portfolio invested in stocks.
And the next time the market starts to slide and your nerves start to justifiably rattle, come back to this truth: When you are young the ability to buy more shares at a lower price is an advantage, not a disadvantage. Look, I am not asking you to break into a celebratory jig every time the market falls. But don’t run the other way in panic either. Do not bail. The downdrafts are in fact a great opportunity to build retirement security. That brings us to the importance of dollar cost averaging.
TAKE ADVANTAGE OF DOLLAR COST AVERAGING
One of the great aspects of making periodic investments in your 401(k) and IRA is that it helps you take advantage of an investing strategy known as dollar cost averaging (DCA). By consistently investing sums every paycheck into your 401(k), or making monthly transfers from your checking account into your IRA, you will sometimes purchase stock when prices are high and sometimes when they are low. But the average over the entire time you are investing is far better th
an trying to invest one big lump sum—assuming you have it. When you use DCA you smooth out your average purchase price. And if you have decades until you will even begin to need the money, the likelihood is that those shares will have grown in value over that time. Moreover, committing to a steady and automatic savings plan—that’s what dollar cost averaging is at its heart—ensures you will stick to your periodic investing. And that’s the most important step in realizing your retirement dreams.
Buying stocks for your retirement accounts when values are lower is actually what you want. Yes, you read that right: I said you want stock prices to be lower, not higher. Let’s say you have $100 to invest and a stock trades at $12 per share. Your $100 will buy about 8 shares. But if the stock price is $10 you get 10 shares. Now let’s jump ahead to some future date when the stock is at $15 per share. If you own 8 shares your account is worth $120. If you have 10 shares, your account is worth $150. See what I mean? When you are young and have decades until you will need your retirement money, the ability to buy more shares when prices go down is what you should be rooting for. The ability to save for retirement when prices are lower is a big advantage.
HOW MUCH TO INVEST IN STOCKS
The reality is that each of you must decide for yourself how much of your money to invest in stocks. If you were among those who’ve developed a fear of the market, I hope I have convinced you to rethink your position. Now, that said, I am not telling you to back up the truck and pile everything into stocks. No, no, no. Do that and you can’t help but panic when there is a big market drop. Besides, historically, having at least 20% or so of your account in less volatile investments—such as bonds—has generated almost as strong gains as a 100% stock portfolio, but with less dramatic price swings when the markets go down.
What you want to do is create a mix of stocks as well as bonds and cash. A general rule of thumb worth considering is to subtract your age from 100. So if you are 35, consider a portfolio that has 65% or so in stocks. And just to make sure we’re all agreed on why you can’t afford to be 100% in bonds and cash: because your money will likely not grow at a rate that can keep pace with inflation.
The bottom line is that you do not want to be an either/or investor. You want both. Some stocks, some bonds. Your 401(k) plan or the discount brokerage where you invest your IRA likely has a free calculator to help you determine an age-appropriate mix of stocks and bonds that is in line with your appetite for risk. Or anyone can use the asset allocation calculators at vanguard.com and troweprice.com.
I think I have been quite clear that the absolute best move for you is to invest a significant portion of your money in stocks when you still have decades to go until retirement, let alone the two or three decades you could live in retirement. That is indeed my best advice. But if you remain unconvinced, and your truth is that you never want to have much or any of your money invested in the stock market, that’s your truth to stand in.
But you must also accept the truth of the trade-off you are making: If you do not invest in stocks you will have no opportunity to generate inflation-beating gains. Therefore you will have to commit in a serious way to two important adjustments:
• Save more. This is simple math: If your portfolio will be invested in only lower-risk investments that might average 3–4% or so, you need to save more than if you were invested in a mix of investments that might produce returns of, say, 6% or so. Let’s say you are investing $500 a month for retirement. If that account earns an average annualized 6% a year for 40 years it would be worth about $995,000. If it earns an average annualized 4.5%, it would be worth $670,000. If you want to end up with the same $995,000 you would need to increase your monthly savings to about $740 a month.
• Plan on living on less in retirement. If you make less on your retirement investments, then you will have less to support you in retirement. That isn’t necessarily a problem if you create a lifestyle where you are in fact living below your means and can continue that way in retirement. But there’s no way in your 20s and 30s to anticipate what your expenses will be 40 and 50 years from now. It’s hard to know what they will be 2 years from now! However, I can tell you that if you live honestly today—below your means, but within your needs—you will not only be able to save for retirement, you will have a less expensive lifestyle to maintain in retirement. But if you are saving less today and not investing for growth, and you are not living below your means, well, there is not any sort of truth in there.
CHOOSING THE BEST OPTIONS WITHIN YOUR 401(K)
In most 401(k) plans your employer will offer you investment options that are usually made up of 12 or so mutual funds and possibly their company stock. And then it’s up to you to figure out how to invest among all those options.
Many 401(k) plans also offer a simpler approach: a target-date retirement fund that makes all those allocation decisions for you, so rather than have to figure out the right mix of different types of stock and bond funds you can invest in the target fund tied to your expected retirement date—the year will be listed in the name of the fund—and the fund company will take charge of deciding how to allocate your money within the target fund among different types of investments. The way most target funds work is that they own shares in a bunch of other funds. Through one single investment you are buying smaller shares of a mix of different stock and bond funds.
My strong preference is that you do not use a target-date fund. I recognize they are much easier—you just find the right target date, put all your money in them, and you’re all set. My primary concern with target retirement funds is that no matter your age, a portion of your money will be invested in bond funds. I have never liked bond funds. Bonds, yes, but not bond funds, and for one simple reason: Since there is no set maturity date for a bond fund, you are never guaranteed you will get your principal back, as you are with a bond (assuming of course that the bond does not default, which is indeed extremely rare). And right now I think it is very dangerous to have any money in long-term bond funds. As I write this in early 2011, interest rates are at historic lows. They may stay there for a bit, but eventually they will need to rise. And the way bonds work, when rates rise, the price of the bond falls. If you are invested in a bond fund that focuses on long-term bonds, you will suffer big losses. And if you are in a target retirement fund you can’t control what your bond portion is invested in. You may be stuck with some of your money in long-term bonds. Therefore I would much prefer that you build your own portfolio of funds from the menu that is offered in your plan.
HOW TO BUILD THE BEST 401(K) INVESTMENT PORTFOLIO
1. Decide on your mix of stocks and bonds/cash. As I mentioned earlier, this is yours to determine, based on your truth. From a purely financial perspective, when you are young the majority of your money should be invested in stocks. Start with the rule of thumb of subtracting your age from 100. So a 30-year-old might aim for 70% in stocks. If you’re feeling less or more confident about your ability to sleep well in volatile times, adjust accordingly; I would rather that 30-year-old ratchet down to 60% in stocks so she can feel more confident during rough times, than have her commit to 70% or more and then panic when the market slides and pull out of stocks completely.
2. Look for the lowest-fee funds offered in your plan. Every mutual fund offered within your plan charges what is known as an annual expense ratio. The annual expense ratio is deducted from a fund’s gross return. For example, if a fund earns 5% and its expense ratio is 1%, the real return you will get is 4%. Some funds have expense ratios above 1.5%. Others, such as index funds, charge just 0.20%. Make it a goal to first find the funds with the lowest expense ratios in your plan. Keep an eye out for any funds that are index funds. This means the fund mimics the investments of a fixed benchmark index, such as the S&P 500, rather than relying on a portfolio manager to decide what to buy and sell. Most index funds have lower expenses than managed funds. Low-cost index funds are a reliable option.
3. For the stock portion: Typically 401(k) pl
ans offer funds for large, medium, and small companies. It’s a good idea to allocate a portion of your portfolio into each category. Stocks of large established companies can provide steadier returns—and often dividends—while midsize and smaller companies typically hold the possibility of bigger growth opportunities. Take a look inside your 401(k) plan to see if there is an index fund with the name Total Stock Market. The “total” means it invests in a mix of large, midsize, and smaller companies. That’s a great way to own big and small companies. An index fund with the term “500” means it is focused on large-cap stocks that are part of the S&P 500; that, too, is a fine choice, though you might want to put a small portion of your money in other funds within your plan that also invest in midsize and small cap funds.
I recommend that 85% of your money be invested in the Total Stock Market fund or a mix of large/midsize/small funds offered in your plan. If you build a mix of large/mid/small funds you might consider following the lead of how a Total index fund currently invests in the three types of stocks: about 70% large caps (S&P 500), 20% midsize, and 10 percent or so in small caps.
The other 15% of the stock portion of your retirement account should be earmarked for an international fund. A diversified international fund that focuses on both developed markets and faster-growing emerging markets is your best move. Or if your plan offers a choice of different international funds, put 10% in the developed markets fund (it may have the abbreviation EAFE in it—that stands for an index of developed countries in Europe, Australasia, and the Far East) and the other 5% in an emerging markets fund.
Just be sure that before you invest in the emerging markets fund, you check to see if the main international fund offered within your plan already invests a portion of its assets in emerging market stocks. Your plan’s website may have access to this portfolio information. If not, you can find it at the Morningstar.com website. Just type the five-letter ticker symbol for the fund in the search box at the website, and then click on the Portfolio tab. If that fund already has exposure to emerging markets, you can just stick with that one investment.