Thursday, July 12, 2012

Retirement Saving For Beginners

How to Start: The sooner a young professional can start saving for retirement the longer they can let the miracle of compound interest work for them. I know that most 20 somethings that are fresh out of college feel like there is no extra money for retirement savings once all the bills are paid (student loans anyone?). I have two pieces of advice for these retirement virgins:
  1. Start Small
  2. Make it automatic
By starting small and making the process painless by automation, you can exponentially increases the likely hood that you will be able to make retirement saving a positive habit. If a young professional is lucky enough to get a match on their 401K at work they should start saving $50 - $100 dollars per month in their plan. By setting this up through their plan the money will be automatically contributed out of each paycheck. The goal in this case is to increase the monthly contributions to the maximum amount that the employer will match ASAP (within a year if possible). By slowly escalating the amount saved each month you won't see a dramatic step change in their disposable income which as I previously mentioned will increase the chances that the habit will be manageable and sustainable. 

No 401K?: In the event that a 401K is not offered by your employer I would recommend saving through a Roth IRA and a low cost provider like Vanguard. I would still start with $50 - $100 per month with increases as possible.  

Investment Choices: In either the 401K or Roth IRA method I would recommend that a 20 something that is an investing novice put their savings into a low fee Stock Index Fund. An index fund will mirror the stock market as a whole. This eliminates the need for a young professional to know anything about the stock market. The index fund will have moderate risk for a stock fund and the low fees will help boost the compounded return. I would recommend a 90% - 100% stock allocation for a young professional because they should have at least 30 years until retirement which allows them to take the additional risk that stocks have over bonds or money market funds. Over a 30 year time frame stocks have historically had the best return of any investment class. For a super risk adverse individual I would recommend putting 10% of their savings in a total Bond Fund to offset some risk.

Disclaimer for Those with Credit Card Debt: The only instance when I recommend that an young professional not save for retirement is when they have outstanding credit card debt. Credit card debt is typically over 10% interest which is higher than a reasonable return from the stock market. In this case it doesn't make sense to make 10% return on your retirement savings when you are paying 20% interest on your credit card debt. The best financial decision in this scenario is to focus on paying off the credit card debt ASAP, and then utilize the methodology I outlined above.

Summary: For any young professional just starting to save for retirement you should start small ($50-$100 per month), automate contributions, increase contributions incrementally, and focus on low cost stock index funds. This simple recipe will start you down the path of comfortable retirement.

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