The decisions you make about your pension retirement plan are amongst the most important decisions you will ever make. The quality of your life after you retire depends on the amount you save and how that money is invested. And more importantly, it also depends on how early in your career you start saving and investing for retirement. Saving for a comfortable retirement takes 30-40 years, and is not something that can be left until you are 50.
Planning for retirement is becoming more important as people are living longer, and often retiring earlier.
What does a pension retirement plan consist of?
A retirement savings plan consists of the following:
- Working out how much will be needed in retirement.
- Working out how much needs to be saved.
- Deciding which vehicles to invest in.
- Deciding on the mix of assets over time.
How much do you need to retire?
This is not a question you can ever answer definitively. It will depend on the lifestyle you want when you retire and the inflation rate between now and the day you retire. The best you can do is to use your current monthly expenses as a benchmark.
A good way to begin is to use your take-home pay as an estimate of what you spend every month. That’s your salary after deductions for tax and 401(k) contributions. You can deduct your mortgage payments if your mortgage will be paid off by the time you retire. The number you are left with is a good indication of what you probably need to continue enjoying your current lifestyle. There may be some other expenses that will be lower in retirement, while others such as healthcare may be higher.
You can also deduct any other forms of income you will receive when you retire. These include a pension if you have one, social security and rental income from other properties you may own.
Now that you know what you will need if you were to retire tomorrow, you need to work out how much you need to fund that amount. A common rule of thumb is that you will need 25 times whatever you will spend in a year. That’s based on the 4 percent rule, which states that you can withdraw 4 percent of your savings every year and never run out of money. And that is based on long-term investment returns of 7 percent and long-term average inflation of 3%. Studies have found the four percent rule to have worked over 96% of thirty year periods in the last 100 years.
How much do you need to save?
There are plenty of calculators on the web that you can use to calculate how much you need to save every month. This one from Bloomberg keeps it nice and simple. The basic principle is that you save a percentage of your salary, and as you salary increases over time, so does the amount you save. Obviously, you should save as much as you possibly can, and the results from these calculators should be taken as an absolute minimum.
Retirement Savings Vehicles
If you are employed you will probably have a 401(k) account which allows you to contribute monthly, and invest that money on a tax-deferred basis. This will be the core of your retirement savings plan, but you should supplement it with other savings.
The two most common vehicles to supplement a 401(k) account are an Individual Retirement Account (IRA) and a brokerage account.
An IRA offers many of the same benefits as a 401(k) and you can own both. If you do have both, you’ll lose the tax benefits in your IRA if you earn more than a certain amount. In most cases, you will want to contribute as much as possible to a 401(k) first, especially if your employer matches those contributions. But once you have contributed the maximum to your 401(k) you should contribute to an IRA too. IRAs have more flexibility in terms of investment options.
A stockbroking account will offer you far more flexibility and the ability to create a very focused portfolio. The risk of picking individual stocks is that you may trade far too often, and you may get caught up in bubbles in ‘hot’ sectors. Saving for retirement with a stock account would be seen as a long-term investing account, not a trading account. If you would like to trade, open a second brokerage account with money that falls outside of your retirement savings.
Deciding on the Mix of Assets Over Time
For the most part, asset allocation comes down to stocks vs bonds. The old rule of thumb was that you should always have 100- your age in stocks. So if you are 30, you should have 70% of your portfolio in stocks. That rule has become dated as people live longer and retire earlier. If you are 60, then having 40% of your portfolio in stocks will not allow you to keep growing that portfolio fast enough to live off it for another 30 years.
The updated model suggests subtracting your age from 120. So at age 30, you would only have 90% in stocks and 10% in bonds. That may seem risky, but remember you will have another 30 years for your portfolio to recover from a stock market crash and you will be making most of your contributions later.
A 1000 word article is not long enough to properly explain a retirement pension plan. However, this article should give you a good framework to work with. You will need to do a lot more research to determine the right asset allocation model, the best vehicles and the best assets to put in those vehicles. Somewhere along the way it’s a good idea to speak to a financial advisor or financial planner to make sure your plan is ideally suited to your individual needs.
Most people simply don’t save enough. It’s easier said than done, but ensuring you save enough comes down to adjusting your lifestyle to your savings plan. In other words, save first and then spend what’s left, rather than spending first and savings what’s left.