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.
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 Compounding occurs as early returns are re-invested rather than withdrawn, increasing the principal and consequently the rate of return every time.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 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.
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:
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.
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.
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:
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
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