Contributing to your retirement account is admirable, necessary, and a basic tenet of responsible personal finance.
First, however, you have to open one.
Opening a retirement account is a little more complicated than opening a checking or savings account, because a retirement account is invested — and it’s up to you to decide what those investments will be.
An individual retirement account, or IRA, is opened by a person as opposed to a company. While it’s a stretch to say an IRA can be invested in anything, there are many securities and funds that can be included.
A 401(k), on the other hand, is opened by a company for its employees and generally provides a menu of investment options during signup. A 401(k) also often has a default investment setting, so even if you don’t choose your investments, your money is invested.
These two accounts have something in common: You’re going to have to make some choices. Everyone’s portfolio will and should be a little different, but here are a few things to keep in mind when choosing your investments.
Your investments should be tailored to your specific situation.
The reason every working person doesn’t have identical investments for retirement savings is that we all differ in three particularly important ways: how long we have until retirement, how much we’ve already saved, and how much money we’ll need when we get there.
Certified financial planner Ken Moraif recommends starting with what he calls your “magic number,” or how much you’ll need in retirement. “Essentially, you have sources of income in retirement other than investments, like a pension, Social Security income, or real-estate income,” he says. After adding up that income, you then subtract the expenses you’ll have once you retire.
“For most people, there’s a deficit, a negative number,” Moraif says, “because their expenses are higher than income.” You then annualize that number, so that the figure at hand represents your deficit over an entire year, and multiply it by 25 to get an estimate of how much money you’ll need when you retire. For example, if your monthly deficit was $US2,000, you’ll want at least $US600,000 saved for retirement.
From there, you’ll be able to get an idea of how aggressive your investments need to be to get that much money by the time you retire. Moraif calls the rate of return required to achieve that number your “hurdle rate,” and it’s one that a financial planner or brokerage representative should be able to help you calculate.
Err on the conservative side.
Even if your risk tolerance is high, Moraif says retirement savings aren’t the place to test your limits. “My belief is that you should take only as much risk as necessary to accomplish your financial goals,” he says. “If the rate of return you need is 10% and you go chasing 20% returns, you run the risk of getting caught in a bear market, and then you can’t retire.”
Consider defaulting to a target-date fund.
For that reason, Moraif recommends target-date funds for the typical retirement investor. “Most people don’t have the ability, or time, or inclination to do the amount of maintenance required on a portfolio you construct yourself,” he says.
“Target-date funds are preconstructed portfolios with a date attached to them,” he explains. They’re named according to the year you plan to retire, so “target date 2025” indicates a portfolio for someone retiring in 2025. “The longer the target date is, the more aggressive it is,” he adds.
Moraif also suggests a target-date fund hack: Target-date funds get more conservative as they get closer to the retirement date. So, if you plan on retiring soon, but need to be more aggressive with your investments based on what it will take to achieve your magic number, you can choose a target-date fund with a date further into the future than you actually plan on retiring.
You don’t have to do it alone.
If you work with a financial planner or wealth adviser, you can ask them to choose your account’s investments. If you’re operating solo, though, it’s a little trickier.
Moraif points out that employers offering 401(k)s usually provide a degree of education surrounding their investment options, and that the brokerage holding your IRA might also have educational resources.
Another option for those who want the expertise of a financial adviser without the steep bill is surrendering your retirement accounts to an online investment management platform, often referred to as a “robo-adviser.”
While Moraif notes that a robo-adviser can’t manage your 401(k), he admits that it might be a viable option for the retirement investor with an IRA who doesn’t have a particularly complicated financial situation. Robo-advisers evaluate an investor’s risk profile and use algorithms to invest their money accordingly (in fact, one baby boomer now invests all of her retirement savings with one such company). With this service, the company chooses your investments for you.
It’s OK if your investments aren’t perfect.
Ultimately, says Moraif, simply getting started is more important than cherry-picking your investments. “Too many times people are intimidated by investing for retirement,” he says. “They don’t know what to invest in, or they feel like there are too many choices. But the advantages of investing every month over time outweighs all the choices you make with the investments, whether they’re right or wrong. The important thing is that you do it.”