Start a Retirement Plan (Level II to Financial Freedom)
Once you have completed Level I (Coping with Bad Debt) in the Financial Freedom game, you will move on to Level II: Retirement Planning. There’s a lot to consider when setting up your retirement plan successfully. At this level, we will only cover the accumulation portion of retirement planning, not the distribution phase (which occurs when you retire). To set up your retirement plan, start with the Top Three: Determine your goals, the number of years until retirement, and your risk tolerance. The goal of this initial process is to establish the average planning path for how contributions and appreciation will add up to enough money for you to turn into income at retirement.
When I opened a retirement account, it was in 1998 and I think Roth IRAs had just been established. So, I went through the whole process with a financial advisor, who was also my neighbor. I wanted to retire at 65, I wanted $3 million, and I had a high tolerance for risk. I always assumed that a high level of risk was required for any chance of a large reward. I don’t think like that anymore! When the dot-com bubble burst in 2000, I had a new feeling about my “high risk tolerance.” After paying all the brokerage fees, I think I lost about 50% of my investment that year. Because of that loss, I was forced to reassess what it meant to have a high risk tolerance. I’ve since learned that you don’t have to take high risk to get good, consistent returns. In fact, it’s probably best not to.
A lot of people don’t seem to get satisfactory answers as to the point of those 3 planning questions. So I will say that the main point in identifying your goal, time horizon, and risk tolerance is to establish your portfolio’s asset allocation. Your asset allocation is the combination of various asset classes (such as stocks, bonds, and real estate) that you will target, in percentage terms. Higher risk tolerances allow for greater volatility. Since stocks are more volatile than real estate and bonds, a higher risk tolerance would establish a portfolio with a higher percentage of stocks. Lower risk tolerances seek to reduce volatility and thus point to more fixed income in asset allocation.
How does asset allocation work? It works in two ways. One way is diversification. Because asset classes react differently to the changing environment, diversification, over time, produces better results with less volatility. Why is that? All investments are affected by 4 main factors:
1) commodity prices such as input prices, specifically oil,
2) interest rates as the cost of borrowing,
3) inflation (or deflation) as a combination of federal policy, monetary policy, and general prices, and finally,
4) the economy, in terms of growth (corporate and economic).
Investments are affected by the nominal numbers of each of these 4 factors, as well as the exchange rate. For example, you may have low interest rates, but if those interest rates suddenly start rising rapidly, then the market will begin to price in that change. The exchange rate can greatly affect prices and market volatility. Remember, the ultimate goal is for the market to be a future earnings discount, and any big change in any of these four areas will greatly affect the calculation.
The second way asset allocation works is through “rebalancing.” Rebalancing allows for a systematic process of buying low and selling high. Rebalancing your assets at fixed points throughout the year, say twice a year, allows you to sell asset classes that have grown more than your target allocation percentage and buy asset classes that have fallen below your asset allocation objective. This provides a process that automatically and systematically buys low and sells high.
Now, why are we talking about this in Level II: Setting Up Retirement? It is because I recommend that you find a service that can do all this for you in the cheapest way possible. I recommend looking at the “robo-advisors”: WealthFront, Betterment or Personal Capital. These companies walk you through the planning questions, set a risk tolerance number from 1.0 to 10.0, and then set up an asset mix based on your profile. They allow you to set up automatic contributions and will handle rebalancing on a set schedule. The important point is to have all this within an automated system so you don’t even have to think about it. You can also buy index ETFs directly, with no trading charge, within a broker like TDAmeritrade. They offer 100 free index ETFs. However, keep in mind that ETFs are not as automated as robo-advisors. You would start with a robo-advisor account and then optimize and improve it later on as you start to improve your investment skills.
So, to reach Tier II, you must set up a retirement account and automatically contribute 10% of your income. I would generally stay away from company 401k plans, unless they provide a match. If they provide a match, then it’s free money and you can start Level II by setting up your 401k, but only for the amount the company will match. Why? Because 401k plans have a lot of hidden fees and are quite expensive to administer. Most of the people who get rich from 401k-land are the providers, not the participants.
Also, how do you know you’re on track to retire? I would use these very general statements. He wants “four figures” at 20 so that someday at 30 he can hit “five figures.” And you do that so you can hit “six figures” sometime in your 40s. If he does that, he’s looking to hit “seven figures” sometime in his 50s. And if you want extra credit, then you’ll hit “eight figures” sometime between your 60s and 70s. If you’re 27 and have $4,000 in your retirement account, you’re on the right track. If you’re 38 and have $55,000 in your retirement account, you’re generally on the right track. If you’re 44 years old and have $145,000 in retirement, then you’re on the right track.
The main point here is that you need to have a “four figure” portfolio before you have a “five figure” portfolio and so on. And that a retirement portfolio will use the power of compound interest and a long-term horizon to generate great returns. This is a very general rule that does not apply to everyone. Also, this does not allow someone to skip the “objectives” section of creating a risk and investment profile. It should be used as a very general rule of thumb. I will give another rule of thumb in later articles. By now, I hope you’ve found this point somewhat helpful and enlightening on how to win at Level II of the financial freedom game: setting up a retirement account and investment process.
So, are you ready to complete Level II: Set up a retirement account and save 10 percent per year? You can do all of Tier II in one step: set up a Wealthfront account and set up an automatic monthly contribution to a traditional or Roth IRA. Or, you can set up your 401k at your company, as long as they have a generous matching policy. Or, you can set up a TDAmeritrade account, set up an automatic monthly contribution, and invest using their free index ETFs. All of these approaches put you on the path to investing for retirement. You can improve it later. The goal is to just get started and then make management automatic.