A 2017 survey conducted by GoBankingRates indicates that 33% of Americans have no retirement savings and another 23% have only between $0 and $10,000! Sadly, too many people are ill-prepared financially for their future, whether it be for retirement or an unexpected emergency. Fortunately, for adults in their 30s and 40s, there is still plenty of time to fix this problem but it requires a plan of action. A goal without a plan is just a wish.
Saving needs to be an active process and a priority, not an afterthought. While saving is not always easy, a sure way to accomplish it is to automate your savings directly from your paycheck, therefore saving before you spend. Warren Buffett best described how to approach saving when he said “do not save what is left after spending, instead spend what is left after saving.” Once the process to build savings is set, those accumulated funds can be put to work for you with proper investment.
H O W M U C H T O S A V E ?
Your budget should allocate an amount towards saving which incorporates the three main savings goals:
- emergency fund and upcoming large expense
The amount you save for each of these goals depends on the cost and time horizon. The first goal is saving enough for an emergency fund, as well as saving for upcoming large purchases. You should have cash equal to 3 – 6 months of expenses as an emergency fund to cover unexpected expenses such as a car repair. An emergency fund has a short time horizon (you might need funds next month) so you want to meet this goal first. Next, you can work towards saving for an upcoming large purchase, such as a down payment for a home.
Gone are the days of employer pension plans. The onus is almost completely on the individual to save for retirement. The amount you save for retirement is dictated by both the rate of return and the time period over which you save (i.e. the sooner you start saving, the less you have to save each year as your money has time to compound). We advise individuals to save at least 10% of their gross pay toward retirement, and to increase that saving rate to 15%-20% gradually over time. If your company has a retirement plan in place, this can be done simply through a payroll deduction.
With retirement on track and emergency funds in place, saving for your children’s education can now be a third goal. We advise making education savings a lower priority than retirement savings as there are many ways to finance education but very few ways to finance retirement.
Although there are three distinct savings goals, saving is not done in a silo. You do not save strictly for one goal, and defer others until the first is achieved. Rather, you must prioritize your goals, but still work in tandem.
I N V E S T I N G – U N D E R S T A N D I N G P O R T F O L I O C O N S T R U C T I O N
How you invest your money (ex. stocks vs. bonds) will depend on your investment objective. In turn, your investment objective will depend on your time horizon.
The relationship between time horizon, investment objective, and investment options is depicted by the chart below. If there’s a long time horizon (7+ years) before the funds are needed, then the investment objective is for growth. In this case, the funds should be invested in stocks. If there is an intermediate time horizon (3-7 years), then the investment objective is for income. Therefore, the funds should be invested in fixed income (bonds). If the time horizon is short (0-2 years), then the investment objective is preservation of capital. In this case, the funds should be invested in cash. For example, an emergency fund has a short time horizon because it could be needed at any moment. Therefore, an emergency fund should be in cash to be conservatively invested since capital preservation is paramount. Retirement investments, in contrast, may have a long time horizon as retirement funds may not be needed for more than 20+ years. Hence, long-term growth should be the investment objective with investment in stocks.
A S S E T – L I A B I L I T Y M A T C H I N G
While considering your time horizon, how much should you own of each asset class? Asset allocation refers to the different percentages that should be invested in stocks, bonds, and cash. First, use your investment goals to identify the timeframe of when funds are needed, then match the appropriate investment assets to those goals. While there are no guarantees when investing in equities, 7 years should be enough time to mitigate short-term volatility risk, as good years in the market offset bad years. As evidenced by the examples below, asset-liability matching makes it much more likely that you will only need to worry about the risks you can control.
Below is a simple example of a recently retired 65-year-old investor with a $1 million portfolio who needs to spend 4% of their portfolio each year for living expenses, increasing annually for inflation. Cash and short-term bonds cover spending in years 1-3, intermediate-term bonds for years 4-7, then stocks cover their long-term spending needs in years 8 and beyond. The result is a portfolio approximately 70% in stocks, with 30% split between bonds and cash. Most of the retiree’s spending occurs beyond the eighth year, so it’s important to use stocks to hedge against inflation risk. This results in a larger weighting to stocks compared to bonds.
Overtime, the portfolio will need to be rebalanced by selling stocks to replenish the bond and cash positions. Because the investor has 7 years of fully funded spending, the rebalancing can be done in times of market strength and avoided during times of market distress.
Conversely, consider a 35-year-old who is saving for retirement. Using the same asset-liability matching framework, the 35-year-old has no cash needs of her retirement portfolio for 30 years. Consequently, there’s no practical reason to allocate a portion of her retirement account to preservation-type assets as inflation is a more significant risk to her than short-term volatility. In this case, the vast majority of her account (90% to 100%) should be allocated to stocks.
A S S E T C L A S S E S A N D S E C U R I T Y S E L E C T I O N
Each asset class offers varying degrees of risk and return. Stocks are designed for long-term growth, but offer little certainty of return in the short term. Bonds, or fixed income, will produce more income than cash, but are not designed for long-term growth like stocks. Cash and equivalents (ex. money markets) offer a high degree of short-term certainty, but offer no growth and therefore do not protect against long-term inflation risks.
Each major asset class includes a myriad of sub-asset classes. For stocks, examples of sub-asset classes include:
- small cap stocks (smaller companies)
- international developed market stocks
- international emerging market stocks
- real estate investment trusts (REITs)
Similarly, fixed income can be sub-divided among:
- high yield bonds (low credit rated bonds)
- investment grade (high credit rated) corporate bonds
- US Government bonds
- mortgage-backed bonds
- municipal bonds (tax-free)
Diversifying across sub-asset classes offers additional potential return and the possibility to reduce volatility. Remember, though, that any additional yield offered by debt instruments, such as high yield bonds, increases the credit risk and potential loss of principal (there is no free lunch in the capital markets).
A L T E R N A T I V E I N V E S T M E N T S A N D I N S U R A N C E
Developments in the financial markets over the past 10-15 years have given rise to more exotic, alternative asset classes that use sophisticated strategies to either improve returns, generate extra current income, or dampen volatility. Examples include hedge funds, distressed debt, and private equity funds. We do not advise employing such strategies for novice investors.
Insurance products are sometimes marketed as investment vehicles. We believe that insurance intended to protect against a specific risk of loss is appropriate under the right circumstances (e.g. life insurance in case of death). We do not, however, recommend purchasing insurance products as a way to save and invest due to their complexity and cost.
I N V E S T M E N T V E H I C L E S
In selecting the actual securities to own to implement the asset allocation, either you could purchase individual stocks and bonds or invest in actively or passively managed funds, such as mutual funds or exchange traded funds (ETFs). Today, ETFs seem to be the investment vehicle of choice due to their lower cost structure, intra-day pricing, and efficient taxation when compared to mutual funds. Typically though, it is cheaper to own individual securities than it is to own a fund. Owning individual securities also offers more flexibility when managing capital gains and losses. Mutual funds and ETFs, however, allow the investor to gain exposure to a broad basket of securities quickly and efficiently and are appropriate for smaller portfolios.
A C C O U N T T Y P E S
Depending on the source of your savings, you may hold these funds in taxable, tax-deferred, or non-taxable accounts. Taxable accounts are a good place to hold emergency reserves and savings in excess of retirement contributions because there’s no penalty for withdrawals. Traditional IRAs, 401(k)s, and 403(b)s are the most common types of retirement accounts, often referred to as tax-deferred accounts because no taxes are due until funds are withdrawn in retirement. Roth IRAs are a bit different in that after-tax dollars are used to fund the account, no taxes are due on income while in the account, and withdrawals are not subject to taxation. You should seek to fully fund your retirement account before using your taxable account for retirement savings.
U N D E R S T A N D I N G R I S K – I T ’ S M O R E T H A N J U S T V O L A T I L I T Y
It’s important to understand the different financial risks you face when investing. Please review our two planning notes on the ‘Hierarchy of Risks’ and ‘Is Market Volatility the Greatest Risk to Your Retirement?’ for a more complete discussion. Suffice it to say that the media often spends a lot of time focusing on short-term swings in market prices. Market volatility may cause anxiety, but volatility rarely results in a permanent financial loss, especially if you have constructed and diversified your portfolio well. In fact, in a hierarchy of investment risks, volatility is not near the top. While volatility is often portrayed as the greatest risk to savings, the actual risk of having a long-term adverse impact on your savings decreases significantly with time. The three financial risks that pose a greater threat to your savings goals are: behavioral risks, inflation risk, and spending risk.
In conclusion, financial markets can often seem confusing and overwhelming, but, by breaking down portfolio structure components of identifying specific goals, determining the needed savings rate, aligning time frames with the appropriate investment choices, and balancing financial risks, the process becomes much more manageable. There are very few guarantees in life, but, with thoughtfulness and patience, a properly structured portfolio increases the probability of success significantly.