Maybe you have money deposited in your 401k, but haven’t given any thought to how it is being invested? Or maybe you have had a windfall from the sale of a home or business? Or maybe you haven’t even started to save, and the more days that pass, the more hopeless it feels. Last December, I shared some “end of year” checklist items for your financial planning. Several readers have shared that they are overwhelmed by finances and would like something a little more basic to help them get started.1
You asked, so here it is. We will approach the topic following the wise counsel of the New Kids on the Block….step by step.
This will be the first in a four part series, roughly defined as follows (though I reserve the right to change the scope of these as I write).
Part I: What is my investment/savings goal? You are here.
Part II: Asset allocation basics and how do I choose what to invest in?
Part III: Which type of account (IRA, 401k, general brokerage account, etc) is best for what type of investment and how should I think about taxes?
Part IV: The lifecycle of my portfolio: things to think about as I get closer to my goal (how allocation changes when timelines for needing the money shrink, minimum distributions, living off my savings, more about taxes, etc.)
Why invest in the first place?
Why do we even invest at all? Why don’t we just put cash in our mattresses or in a nice, safe savings account (especially with today’s interest rates)?
Investing, especially in equities (think stocks and mutual funds or electronically traded funds (ETFS) that invest in stocks), is founded on the belief that the stock market historically (and over the long haul) is the only investment arena that generally outperforms inflation. What it means to “outpace inflation” is that your money won’t lose its purchasing power over time. Said another way, if you can buy a cart of groceries for $100 today (obviously you are not shopping at Whole Foods), will your money grow enough that it will still cover a cart of groceries that costs $120 in the future (due to inflation)?
Equity growth typically occurs in two ways:
(1) the payment of dividends.
Dividends are a distribution of a company's earnings to its shareholders. However, not all companies or investments pay dividends because some companies take all of their profits and reinvest them in the company itself rather than pay out a portion of the profits in the form of dividends.
NOTE: A good rule of thumb is that your portfolio (if broadly invested in a diverse portfolio) will kick off about 2% in dividends per year. Thus, if you have a portfolio worth $1,000,000, it may generate annual dividends of approximately $20,000. These dividends can be reinvested, or directed to cash to cover expenses.
(2) growth/appreciation of the investment.
The growth and appreciation of an investment is simply when the current value of the investment is worth more than you paid for it.
For example, assume you bought Nvidia stock in 2015 for $5.48 per share. Nvidia is now worth $413.06 per share. Thus, if you sold a single share today, you would have a taxable capital gain of $407.58 ($413.06 - $5.48). If you hold the share, that gain is “unrealized” meaning that it is only an estimate based on moment to moment values, and you don’t pay taxes on it now even though it’s worth more than when you bought it. However, because you haven’t “realized” the sale, you continue to take the risk that it might lose some or all of its value.
A lot of people overestimate how much their money will be worth later, with 26% “not worried enough” about their retirement. There are many explanations, including living through lengthy periods of low inflation (until now) and strong real estate and stock performance (until now), which can create a “wealth illusion.”
Our goal is to always view our financial picture with clarity and transparency, and no illusions (or delusions) about where we might be in 5, 10, 15, or 20 years and beyond.
The Rule of 72
Note: Some Metallica to get the New Kids out of your system.
The Rule of 72 is a general formula that defines how long it will take to double your money at a given rate of return. This calculation can be used for any type of investment (stock, bond, savings account, certificate of deposit, etc).
For example, if you put your money in a savings account paying 4% interest, the rule of 72 tells us that it will take approximately 18 years to double the money (72 divided by 4). This is achieved by not touching the funds at any time during the 18 years - both the initial investment as well as all interest paid in the account.
Conversely, the average stock market return is about 10% per year, as measured by the S&P 500 index.2 Thus, using the Rule of 72, it might only take about 7.2 (72 divided by 10) years to double the value of the investment. And thus, we start to see why investing makes sense for a lot of people.
The Rule of 72 is important as you consider how long you can afford to not touch your savings or investments, and how much you need them to grow in value to achieve your goals.
When do you need the money? What is the time horizon?
The most important thing to consider when investing your hard earned money is when you might need to use that money. The longer it is before you need it (for example, if you are 30 years from retirement), the more calculated risk you can take with it (which increases the likelihood of a larger return). Specifically, the longer your investing horizon, the larger percentage of your portfolio can be invested in equities, which, as we learned above, have historically been the best way to grow your nest egg and outpace inflation.
However, if the money is allocated for a house that you want to buy next year, you do not want to take a chance on a market correction (typically defined as a loss of market value of 10%- 20%). Imagine if you had saved $100,000 down payment, only to find that a market correction reduced its value and it was worth just $80,000 when you actually found your dream house. This is why it is wise to invest different “buckets” of money in different vehicles depending on the time frame that you will need to use the money.
How the rule of 72 works with your time horizon
The Rule of 72 is also the reason that the median Vanguard 401k balance of $35,345 will likely not be enough for retirement. Even with a consistent average return of 10%, it will take 7.2 years to double that (to $70,690), and another 7.2 years to double that (to $141,380), and another 7.2 years to double that (to $282,760). If the person is 40 years old, and plans to retire at 65, unless they get serious about their investment strategy and allocate substantially more to their retirement portfolio, they will likely not have enough to get there.
This is why most investing literature says to start young and keep putting new money in for as long as you are working.
What are YOU saving for?
As you think about your nest egg, it is really more like an egg carton.
Certain holes will be allocated to shorter term needs, others further away (and less predictable). Still others, like paying for a child’s education, may not exist for you at all (and thus that hole might be empty).
The typical types of financial savings needs include the following, and depending on “when” you need the money, will determine where your money is invested and how much risk you can take.
For our purposes, we will focus on retirement because most people intend to retire at some point. But every person’s retirement is different.
For example, the following are two versions of the same song.
The song is the same but the sound and feel is vastly different. Same with retirement - we may both want to retire, but the look and feel of that may be much different for each of us. For example, some people may have a pension, or may believe that social security will be available as a supplement when they retire. Others may plan based on their beliefs that every penny for healthcare and expenses will need to be funded with their own savings. Others may choose to pursue part-time or other passion projects that may reduce the income needs they have in retirement.
With retirement planning, we all have to be our own “educated futurists” and decide for ourselves what we believe, because even the “experts” rarely agree in their predictions.
How much will you need for your goals?
Nearly 30% of millennials and 25% of Gen Zers think they’ll need $1 million to retire comfortably, yet depending on where you live, how you live, how long you live, how early you plan to retire, taxes, and how long you spend building your nest egg, you may need much more.
Most advisors typically suggest that you will need 70%-100% of your current expenses in each year of retirement, though as you can imagine, that number tends to go down as we age and are doing less.
Also, a person who plans to spend their days playing Sequence and reading books from the library may need a lot less than they did in the years where they bought a new car every two years, took exotic vacations, and went out to dinner six nights a week.
But how does this help me figure out my goal for retirement savings?
For example, the average American household spends $61,334 per year. To make it simple, let’s assume the spouses are the same age and plan to retire at the same time, at age 65. They also come from “hearty stock” and will likely both live to be 100.
A good baseline estimate of the retirement savings they might need is as follows:
70% of $61,334 is nearly $43,000 per year (the low end of your estimating range).
Planning for 35 years of retirement (using a range of 70%-100% of current expense levels):
35 years x $43,000 per year = $1,505,000
35 years x $61,334 per year = $2,146,690
This formula is grossly oversimplified because it assumes that the rate of return on investments is approximately the same as the rate of inflation. But for our purposes, it is as good of a starting point as any and it will protect you from the “wealth illusion.”
Oversimplification aside and returning to the calculation, our “example family” will need to create between $1.5 million and $2.1 million of retirement income over the course of their 35 year retirement. Of course, if they start saving at a younger age, their early investments will have more time to grow, making the goal less painful to reach. And they could need a little less if their investment returns consistently outperform inflation, allowing their money to grow faster than inflation eats away at it like Pac-man.
Financial publications are filled with “rules,” including the “4% Rule.” This is a popular retirement withdrawal strategy that suggests retirees can safely withdraw an amount equal to 4 percent of their savings during the year they retire and then adjust that amount for inflation each subsequent year for 30 years. The inflation adjustment each subsequent year is adjusted upward by the rate of inflation to preserve the buying power of the amount initially withdrawn in year 1 (remember that $100 cart of groceries example above? Same principle here.)
In my opinion, the 4% Rule is more valuable as a planning tool than a withdrawal strategy. By reversing the 4% Rule for their first year of required income, we can quickly determine that our example family needs a retirement savings at age 65 of at least $1,075,000.
How did I come up with this? All you have to do is determine what total amount is required to yield your needed annual income using the 4% Rule. Here, the low estimate of necessary annual income is $43,000. By dividing $43,000 by .04 (4%), you show a balance required of $1,075,000. Using the higher estimated expense amount of $61,334, and dividing that amount by .04 (4%), you will see that they need $1,533,350. This figure is below the $2.1 million we estimated above, but slightly more than the $1.5 million. Plus, since the 4% Rule is based on a 30 year retirement period, and our example family targets a 35 year retirement period, we can assume that the savings goal will need to be closer to the high end of the estimated range above.
Again, every model is really simplified. But it gives you an “educated” target to aim for.
Be thoughtful about what you read, it may have a lot of hidden assumptions that do not apply to you
Fidelity offers the following guidance for how much money you should have in your portfolio at various ages as a multiplier of your current salary. Unfortunately, if you just read the highlights, it might be misleading or worse, create a false sense of security. This model assumes successful market performance over time and lower inflation, which may be more “optimistic” than you want to be for planning purposes.
If our “average family” from above follows Fidelity’s model, they only need to save about $613,000 by age 67 if their expenses of $61,334 equals their total salary. But, when we apply the 4% Rule, we see that we can’t generate enough to cover required expenses, even at the lower end of the estimate.
Year 1: Withdraw 4% of the total. Here, 4% of $613,000 is $24,520.
$24,520 is the withdrawal amount for their first year of retirement. The issue is: where will they come up with the remaining money to live on to meet their minimum $43,000 income requirements?
Year 2: Assume the rate of inflation is 3%. Our example family can now adjust their $24,520 withdrawal upward for 3% inflation, making the year 2 withdrawal $25,256. Same problem as above, where does the rest come from?
In this example, the “average family” has two problems: (1) the 4% Rule does not generate enough to cover expenses even in year 1, and (2) this starts retirement at age 67, and remember that the 4% Rule is based on a 30 year retirement. Our “average family” may need to plan for 35 years, so they will either need to save more or withdraw much less.
All of this is intended to help you see that no formula is perfect, but the better understanding you have of how much money you might need, the better planning you can do between now and when you need it.
So what is YOUR first step?
Step 1: Determine how much you spend each year by reviewing your credit cards, bills and other records.
Step 2: Determine how much you need to retire.
To determine how much you might need for retirement, do a few calculations:
Let’s assume you spend about $50,000 per year and that you plan to live a similar lifestyle to how you live now. And let’s assume you are planning to retire at 62 and will live to be 100 (thus you need funds for 38 years).
We know from above that the low end of our expense requirements is about 70% of our current income, or $35,000. Thus, multiplying this amount by 38 yields a retirement savings requirement of $1,330,000.
Using the full amount (100%), the retirement savings requirement in this example increases to $1,900,000.
Therefore, we can assume for planning purposes that you are going to need between $1.3 million and $1.9 million to comfortably retire. However, you also may need to adjust the range when you consider how your lifestyle might change later, especially if you plan to “travel more,” have multiple homes, and do things that cost more than what you have time to do today. Factor this into your final estimated income amount.
We can test these amounts by using the reverse 4% Rule - to produce $50,000 in year 1, you will need $1,250,000 ($50,000 divided by .04). And remember, the 4% Rule can be a bit low because it does not account for longevity, health care expenses, the asset allocation of your portfolio (which we will discuss next time), and retirement periods exceeding 30 years, such as the 38 years in this example.
If you start saving early and regularly achieve a return on your investments that well outpaces inflation, you may reach these savings goals faster and even exceed them - - but the problem is, you (nor I) can predict the future.
Step 3: Identify other large purchases you will have. Add in any other savings goals that you have for the shorter term (house down payment, car, education, emergencies, etc.)
Step 4: Accurately assess where you are right now.
How much do you have today? Subtract out anything that you have allocated for Step 3 because you will probably need to put this in lower risk vehicles. Take what’s left and make a basic assumption that it is for retirement. What is the difference between your goal range established in Step 2, and the amount you have today (reduced by the amount in Step 3).
Want more? Check out the PrepOverCoffee Q&A for questions and answers from readers on this topic.
Write this number down and stay tuned. This is the “gap” we will develop a plan to close in the coming weeks.
Again, I am not a Certified Financial Planner. I am simply a “financial enthusiast” who has learned some stuff over the years.
In some years, the market returns more than that, and in other years, it returns less.