Once you’ve completed Level I in the game of Financial Freedom, it’s on to Level II — Retirement Planning. There’s a lot to consider when successfully setting up your retirement plan. In this level, we will just cover the accomulation portion of retirement planning, not the distribution phase (which happens when you retire). To set up the retirement plan, start with the 3 main factors: determine your goals, the number of years remaining until your retirement and your tolerance for risks. The goal of this initial process is to set the average glide path for how contributions and appreciation will add up to enough money for you to convert into income at retirement.
When I started a retirement account, it was 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 when I was 65, I wanted $3 million and I had a high tolerance for risk. I had always assumed that a high level of risk was required for any chance of a big reward. I don’t think that way 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 reevaluate what having a high-risk tolerance meant. I’ve since learned you don’t need to take on high risk to make good, consistent returns. In fact, it’s probably better not to.
A lot of people don’t seem to getting satisfactory answers as to the point of those 3 planning questions. So, I’ll say the main point of identifying your goal, time horizon and risk tolerance is to set your portfolio’s asset allocation. Your asset allocation is the mix of various asset classes (like stock, bonds and real estate) that you will target, in percentage terms. Higher risk tolerances allow for a higher volatility. Since stocks are more volatile than real estate and bonds, a higher risk tolerance would set up a portfolio with a higher percentage of stocks. Lower risk tolerances look to reduce volatility, and therefore, target more fixed income in the 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 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 pricing, and finally, 4) the economy, in terms of growth (corporate and economic). Investments are affected by the nominal numbers for each of these 4 factors as well as the rate of change. For example, you can have low interest rates, but if those interest rates suddenly start to rise quickly, then the market will start to discount that change. Rate of change can greatly affect market pricing and volatility. Remember, the end goal is that the market is a future discount of profits, and any big change in any of these four areas will greatly affect the calculus.
The second way that asset allocation works is through “re-balancing.” Re-balancing allows for a systematic process of buying low and selling high. Re-balancing your assets at set points throughout the year, say twice per year, allows you to sell the asset classes that have grown larger than their target allocation percentage and buy asset classes that have drifted below their target asset allocation. This provides for a process that automatically and systematically buys low and sells high.
Now, why are we talking about this at Level II — Setting up Retirement? It’s because I recommend you find a service that can do all this for you as cheaply as 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 1.0–10.0 and then set up an asset mix based on your profile. They allow you to set up automatic contributions and they will handle re-balancing on a set schedule. The important point is to have all this inside an automated system so you don’t even have to think about it. You can also directly buy the index ETFs, free of a trading charge, inside a brokerage like TDAmeritrade. They offer 100 free index ETFs. Keep in mind, though, that ETFs are not as automated as the robo-advisors. I would start with a robo-advisor account and then optimize and improve upon it later as you start getting better at the skills of investing.
So, to achieve Level II, you need to 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 to the amount the company will match. Why? Because 401k plans have many hidden fees and are quite expensive to manage. Most of the people getting rich in 401k-land are the providers, not the participants.
Additionally, how do you know you’re on track to retirement? I would use these very general statements. You want “four figures” in your 20’s so that some day in your 30’s you can achieve “five figures.” And you do that so you can get “six figures” some time in your 40’s. If you do that, you’re looking to get to “seven figures” some time in your 50’s. And if you want extra-credit, then you achieve “eight figures” some time in your 60’s or 70’s. If you’re 27 and you have $4,000 in your retirement account, you’re on track. If you’re 38 and you have $55,000 in your retirement account, you’re generally on track. If you’re 44 and you have $145,000 in your retirement, then you’re on track.
The main point here is that you need to have a portfolio of “four figures” before you have a portfolio of “five figures” and so on. And, that a retirement portfolio will use the power of compound interest and a long time horizon to generate large returns. This is a very general rule that does not apply to all. Also, this doesn’t allow for someone to skip the “goals” section of building a risk and investment profile. It should be used as a very general rule of thumb. I’ll give another rule of thumb in subsequent articles. For now, I hope you’ve found this point somewhat helpful and enlightening for how to win at Level II of the game of Financial Freedom — setting up a retirement account and investing process.
So, are you ready to complete Level II — Setting up a Retirement account and save 10% per year? You could do the whole Level II in one step — setting up a Wealthfront account and have automatic monthly contribution set up into a traditional or Roth IRA. OR, you could set up your 401k at your company, as long as they have a generous matching policy. OR, you could set up a TDAmeritrade account, set up monthly automatic contribution and invest using their free indexed ETFs. All of these approaches get you on your retirement investing track. You can improve upon it later. The goal is to just start and then make the management of it automatic.