Saving for RetirementWhy save for retirement and the impact of fees on investment performance.
Those saving for retirement today have unique challenges compared with past generations. Many companies offered pension plans that rewarded a lifetime of work with guaranteed income for their retirement years. And if you weren't lucky enough to receive a pension, at least there was Social Security - a guaranteed lifetime benefit paid by the federal government. Many retirees received both a pension and Social Security.
The world is a different place today, at least for those who are not yet retired. Pensions for most private sector employees have been all but phased out over the past few decades. And Social Security, a system never paid for by retirees' own contributions, but always by the contributions of current workers, could be forced to reduce benefits over the coming decades since there will be fewer workers relative to retired people (unless taxes are raised). For those still working, and especially those just starting their working lives, the future is filled with uncertainty. You need to start actively planning for your retirement.
Gloom and doom aside, one important question to ask yourself is how exactly you want to live during retirement. And you should plan on doing a lot of living - the average American now lives almost twenty years longer than when Social Security was first developed. It's not unusual for people to live well into their 80s, and those over 100 are the fastest growing age group today. Do you want the freedom to travel the world to visit friends and family or would you rather depend on a part-time job to make ends meet?
The best way to protect your future is to start a disciplined retirement savings plan as soon as possible. When combined with the security of home ownership, a retirement savings plan means that you don't have to strike it rich to be comfortable in retirement. If you are relatively young, you don't necessarily need a lot of money now to secure your retirement, you have something just as valuable - time.
The Power of Compounding
When you plan to grow wealth over a lifetime, one of the most important concepts to understand is compound interest. Compound interest arises when interest is added to the principal, so from that moment on, the interest that has been added becomes the principal and also earns interest. So if you saved $100 that earned 8% interest per year, at the end of the first year you would have $108. During the second year, interest is earned not only on the first $100, but the additional $8 - for a total of $116.64. That extra 64 cents may not sound like much, but over a lifetime, the effect can be substantial.
Here's an example - say you start saving $200 per month at age 22, and save until you are 65. If you earn the historical average stock market return of 8.5%, after 43 years you would not only have the $103,200 you saved, but you would have an additional $946,377.17. That's a total of over $1,050,000, all for $200 per month.
But what happens if you don't start saving until you are 40 years old, cutting your years of contribution and compounding from 43 to 23? Rather than over one million dollars, you would be left with a somewhat less impressive $167,000.
Or what if you had simply saved $3,000 from a summer job each year during college and never added another dime? That $12,000 investment at an 8.5% return would be worth over $450,000 at age 65 all because of compounding - not bad at all.
These examples assume a rate of return that's based on past averages (nobody can tell the future) and they also assume tax-free growth in an IRA, 401(k) or similar account. But they do serve to illustrate an important point - by starting early, you can dramatically increase your returns and your quality of life at retirement.
The Consequences of Investment Fees
There is a time when compounding actually works against your overall returns, and that's when you include the management fees typical of many mutual funds. Also known as the "expense ratio," this fee can take a substantial bite out of your savings. A typical expense ratio for a mutual fund is 1.19% - meaning that 1.19% of your total balance is taken each year as a management fee. So if you had an account worth $100,000, you would be paying nearly $1,200 per year in fees. And these fees are paid regardless of whether you made or lost money that year.
The effects of this expense ratio are even more striking when you consider the damage done to long-term gains. In a previous example, someone who saved $200 per month for 43 years would have a nest egg of over $1,050,000 assuming historically average stock market returns. But what happens when you subtract an average management fee? Rather than $1,050,00, the total becomes just $721,000 - a difference of $329,000 (or 31%).
In addition to the expense ratio, some mutual fund companies charge a "load," or fee on the purchase and/or sale of mutual fund shares. The fee upon fund purchase is call a "front-end" load, the fee on the sale of the fund is known as a "back-end" load. So in our example, putting our hypothetical investment in a fund with a 5% front end load would reduce the total by approximately $72,000, leaving a total of $649,000. If the fund also charged a 5% back-end load, that would reduce the total by another $32,500, leaving a final balance of $616,500 - that's a total difference of $433,500 (or 41%) of our original example, all because of a 1.19% management fee and 5% front and back-end loads.
When evaluating investment options, pay close attention to the expense ratio and load percentages - they can make a much bigger difference than one would ever expect. Many experts suggest investing in funds with the lowest fees, even if some "expensive" funds have offered better recent returns (remember that good past performance does not automatically equal future results).
Because each of the main three types of investment classes involve different levels of risk and reward, you will often hear the term "asset allocation" in regard to investment planning. Asset allocation simply means the percentage of your entire investment portfolio that is invested in each of the three main asset categories.
Younger investors, who have years before retirement, typically choose a higher percentage of stock ownership - this offers greater opportunity for growth, but also more risk. As investors get older and preserving savings becomes more important than rapid growth, they may gradually transition to a majority of bonds and cash as they approach retirement.