How to Save for Retirement: Using Time and Tax Deferment

You are not alone, if, when trying to sort through endless pages of advice about how to save for retirement, you’re feeling overwhelmed. It’s easy to find tips on anything from cutting back on expenses, so you can contribute more to your nest egg, to which mutual fund will be best for your portfolio. But, whether the advice is “good” generally comes down to how well your situation matches the author’s assumptions. This is why, at Fisher Investments, we believe the best advice you can find on saving for retirement, short of working directly with an adviser like us, is advice which teaches you how to approach the planning process efficiently. As you start looking at retirement advice in an organized manner, it’s easy to see why the first priority is not to think about "how," but "when" to begin your retirement savings strategy.

When to Start Saving

Running out of money later in life is a brutal and uncompromising situation for anyone. One of the biggest risks individuals face is starting to invest too late and/or setting too short a time horizon on their retirement planning. Combine these risks with the tendency of many people to under-estimate the impact of inflation and rising costs in later life, and it's pretty clear that when considering how to save for retirement, starting sooner rather than later has numerous benefits.

By planning early, you can help guard against this possibility, providing more time for gains to compound. Compounding occurs as early returns are re-invested rather than withdrawn, increasing the principal and consequently the rate of return every time.

To understand this process, consider the following example. If you are 30 and invest $5,000 every year for 10 years, and then stop contributing, at the S&P 500's historical average return of approximately 10% per year,¹ you will have accrued more than $850,000 by the time you reach a typical retirement age of 65. Compare this scenario to that of someone who begins saving at 40, putting away the same $5,000 each year with the same rate of return, all the way until they reach 65—who would accrue just under $500,000. The person who waited until 40 to start saving will have put in $80,000 more, yet will come out with more than $350,000 less. This makes it clear: Compound returns mean the earlier you start to save, the more your money is likely to work for you.

Another advantage to investing for retirement early is a greater ability to withstand market volatility. As you may have noticed in our example above, we assumed an average S&P 500 return of about 10%; but in reality, market movements can be far above or below this value on a yearly basis. For example, just since 2000, the S&P 500 has seen annual returns of as high as 32% in 2013 and losses as low as -37% in 2008.² As the average suggests, though, the gains more than make up for the losses over the long term. While you can never know for sure if given years will be up or down, the longer you have to invest, the more likely the extremes offset each other and leave your returns near the average.

IRAs, 401(k)s and Other Ways to Save

Once you’ve started saving, it’s important to become familiar with the available types of retirement savings vehicles. While there are numerous types, by far the most popular are traditional individual retirement accounts (IRAs), and defined contribution plans (like 401(k)s , 403(b)s, 457s, employee stock programs and other varieties). Depending on your career trajectory, time horizon and tax situation, these may form an important part of your retirement savings strategy. However, there are significant differences among them. Below, we cover some of these differences for two common types, 401(k)s and IRAs:

• 401(k)s - 401(k) plans are employer-sponsored, deferred-income accounts that make it easy to invest for retirement automatically with deductions from your paycheck. In many instances, your employer will either add to or match your contributions, creating an automatic return on top of any market performance—that’s a hard deal to beat. With a standard 401(k), contributions are taken from your check before income taxes are calculated, thereby reducing tax liability during your earning years. Furthermore, gains on the money in the account are not taxed by the IRS initially. Instead, the tax is deferred and paid when withdrawals are made, at your ordinary income tax rate. There can be additional penalties for withdrawing before age 55 (though people who qualify as Public Safety Officers can withdraw beginning at age 50).
• IRAs - Traditional IRAs also offer tax-deferred growth on investments, similar to 401(k)s. However, the main difference is that the most IRA accounts are not contributed to or sponsored by an employer (though there are some exceptions used by some smaller businesses). They operate essentially like any other brokerage account, except there may be penalties for withdrawals before retirement age of 59½ (though again, Public Safety Officers can access theirs earlier). As they don’t generally receive employer contributions, there are usually no instant returns for contributions as with 401(k) accounts; however, they provide investors with more flexibility as 401(k)s generally limit investments into a smaller range of products.
• Roth-type Accounts - In addition to standard types of IRA and 401(k) accounts, you’ll also likely find “Roth” varieties. Roth accounts allow your investments to grow tax free like their regular counterparts, but the deposits that fund them come from income you’ve already paid taxes on. Because of this, the withdrawals from these accounts (whether principal or gains) aren’t taxed again so long as the money has been held for at least 5 years. This makes them ideal for investors who expect their income tax burden later in life will be greater than it is now. There are some additional restrictions for Roth types of retirement accounts, however. For example, single tax filers must have a modified adjusted gross annual income of less than $131,000 to make contributions to a Roth IRA.³ Also, Roth 401(k)s cannot have employer matches (any match must go to a standard 401(k) as this money hasn’t been taxed). It’s also important to note that annual limits count contributions to any account of that type. So if you’re already contributing the maximum to a standard IRA or 401(k), you won’t be able to contribute to Roth versions of these accounts.

While popular, these examples are just a small sampling of the types of retirement accounts from which you can choose. There are also other qualified retirement plan options designed to help people in various situations save. The best option for you depends on your investment goals, tax circumstances and career situation. But again, the key is to start investing a portion in them as early as possible to allow compounding to maximize the value gained from their tax advantages and any applicable employer contributions.

Is It Possible to Passively Invest for Your Retirement?

Once you’ve looked at when and where to invest, it’s finally time to start addressing “how.” Recently, the concept of “passive” investing has become popular with people considering how to save for retirement. The concept is simple: Invest in a fund tied to an index that shows long-term growth and keep it there as long as possible, allowing your investment to closely replicate the index’s average return.

While passive investing is often trumpeted by proponents as the best way to achieve consistent returns and solid long-term growth, there can be a significant problem with this strategy. The simple fact is many investors get nervous at the slightest setback and hastily take evasive action. If it wasn't so predictable, it would be astonishing just how many investors are prone to “short-termism,” even when they’re aiming for passivity.

In an ideal world, the passive investor would invest in an index-tied fund—such as an exchange-traded fund (ETF) or mutual fund, lock their portfolio in a darkened drawer and come back decades later to reveal the significant gains. However, media scaremongering and perceptions of volatile markets tap into our brains’ natural tendency to avoid risk or loss, making it very difficult to stay calm and hold steady. Buying and selling “passive” investments in times of optimism or volatility effectively makes them “active.” What determines passivity is less about the investment type than the steely discipline of the investor in the face of the respective temptations or terror presented by either a bull or bear market.

Active managers, alternatively, get results by helping investors better judge when action is needed. If given discretionary authority to trade on your behalf, they can potentially shift your account as soon as they see trouble or an opportunity for extra growth, ideally well before you would know of it. A wise investment manager also knows how to help you stay disciplined even when you are salivating at the prospect of short-term gains or shaking with the fear of further losses. But whether active or passive investing is a better approach for you comes down to your personal discipline and goals.

Risks—It’s All About Trade-Offs

So how, in the end, does all this fit together to help you save for retirement? It’s a matter of looking at all of these questions and understanding the trade-offs you have to make. There is no such thing as the “perfectly safe” retirement investment plan: all decisions involve some level of trade-off.

Every investment—whether it's a bond, a piece of land, a portfolio of stocks or even cash—has an element of risk. Sure, stocks are inherently prone to volatility and the associated market risk, but it is way too easy to overemphasize this aspect. While true that stocks are historically prone to short-term corrections and periods of loss, they also have a history of achieving the highest longer-term returns of any similarly liquid investment.⁴ By way of comparison, bonds are often considered “safe” as they come with stronger guarantees for payments and their values move predictably in relation to interest rates. Despite this, they are still subject to market risk (if interest rates rise, the price of a bond with a lower rate can fall), reinvestment risk (when bonds mature, replacements may have a much lower interest rate) and the risk of issuer default. Depending on your situation, the risks posed by bonds may be more significant than those of stocks. What is important here is evaluating these various types of investments with respect to your goals and time horizon to determine the best option to include in your retirement portfolio.

It is also important to consider that as Americans are living longer, we are becoming more prone to inflation risk and longevity risk. In our sunset years, many costs (e.g., medical care, pharmaceuticals, college tuition for the grandkids, etc.) will continue to grow, and we’ll need to be able to afford them longer. Relying on dated strategies that shift away from growth (and the associated market risk) too early could actually increase the risk of outliving your retirement funds. As we’ve discussed, early planning can help you mitigate many risks by allowing compounding to inflate gains, but this isn’t an option for everyone. So, the key trade-offs to keep in mind are:

• Reducing volatility risk usually means accepting increased risks from longevity or inflation.
• Reducing your risk of shortfall caused by longevity or inflation often means accepting more volatility in your investments to see the needed growth.

Anyone telling you they have the safe solution that renders risk null and void is someone you should probably think twice about entrusting with your retirement planning strategy. What

Whatever you choose to do, early action can help mitigate risk; the sooner you start planning for your retirement, the better.

Fisher Investments was founded in 1979 and manages $83 billion in assets for more than 35,000 private clients and 175 institutions.⁵ Our client-focused service can help you answer all the questions you have about when and how to save for your retirement. Take the next step and contact us today.

¹ Source: FactSet Global Financial Data, as of 7/12/2017. Based on 9.92% annualized S&P 500 Index total returns from 1926-2016

² IBID

³ Source: IRS 2017 Roth IRA contributions limits https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2017

⁴ Source: FactSet Global Financial Data, as of 07/12/2017. Since 1926, stocks have posted annualized returns of 10.0%, outperforming corporate bonds, gold, US Treasurys and municipal bonds.

⁵ As of June 30, 2017