When making big financial decisions — a home, a car, college for the kids — you make must take into account how much income you’ll need for retirement. To put it bluntly: Retirement savings comes first, everything else second.
There’s no shortage of advice on saving for retirement, and an important piece of the puzzle is having a strategy to generate sufficient income when you stop working, as Andrea Coombes recently highlighted. One interesting statistic she cited was a survey showing that 63 percent of people ages 35 to 75 are concerned that Social Security or pensions won’t cover retirement expenses.
Do you think 63 percent is high? I find it surprisingly low, considering most people don’t have pensions and Social Security was designed to supplement other income in retirement.
The three big factors to consider when planning for retirement are: income, mortgage financing and a tax-deferred retirement plan, such as a 401(k). Other issues are important too, but if you can get those three right, you’ll probably be living well in retirement.
The Importance of Income
When planning for retirement, you might focus on the size of your nest egg as the ultimate goal. Some planners put the range at $1 million to $3 million. But that’s putting the cart before the horse. It’s much better to consider how much income you will need.
For example, a $1 million portfolio of investment-grade bonds in today’s low-interest-rate environment may yield 4 percent, or $40,000 a year. When adding Social Security, could you live off that? That might be enough if your financial house is in order, but if it’s not, the writing is on the wall: You need to save more.
Many retirement-advice columns emphasize the importance of “not outliving your money.” But saving up a nest egg and hoping not to outlive it is not a strategy. It’s wishful thinking.
Your goal must be to generate sufficient income with the retirement nest egg so you can cover your expenses, and even save money by spending less than you earn. Invest as if you are going to live forever. Why not? There will probably be at least one other person in your family counting on you not to burn through a lifetime’s hard work. With sufficient income, you will face the wonderful “problem,” when retired, of cash piling up.
The return on the $1 million bond portfolio may be disheartening, but it serves a purpose. It shows how easy it is to figure out how much money you will need. You can find higher-yielding investments, but you will then have to weigh the additional risk against the reward. In the end, it’s wholly possible to sock away a lot of money by controlling expenses.
What can you afford to spend? And what does it really mean to be able to afford something? That may seem to be a silly question, but there is a common belief that you can afford something if you can make the monthly payment. But what about building up savings? For many working couples, the combination of car loans and rent or mortgage payments is so high, it’s almost impossible to avoid living paycheck-to-paycheck.
Next time you finish paying off a car loan, try to resist the temptation of taking on another five-year commitment for a car you don’t really don’t need. Maybe you can drive that “old car” for another five years. Maybe even 10!
Chances are you’re already familiar with the worst excesses of the housing bubble, which included mortgage loans with very low down payments (or none at all), financing with second mortgages or “option payment” loans, which allowed the borrower to make such low payments, the balance actually would increase each month.
The mortgage mess is behind us and most of the silliest loan types are no longer available. But for most people, there’s still a very dangerous financial vehicle out there, which is the 30-year mortgage. That might be a controversial statement because 30-year loans account for most of U.S. mortgage financing. But if you take a real hard look at the numbers, you may find that if you buy “a little less house,” you can afford a 15-year loan. In your favor are lower interest rates and 180 fewer payments.
The median price for a new home during March was $290,000. For an existing home, it was $198,500. Let’s take an example of a home that costs $250,000. The down payment for most mortgage loans is 20 percent, or $50,000 in this case.
At Citigroup Inc.’s Citi Mortgage, the interest rate for a 15-year conforming mortgage loan on Wednesday was 3.375 percent, while it was 4.25 percent for a 30-year loan. Rates can be lowered if you pay points up front, and your annual percentage rate can be a bit higher, but we’re keeping things simple in this example. We’re also rounding to the nearest dollar.
For the 15-year loan, the monthly payment is $1,418. For the 30-year loan, it’s $984. You might go with the sub-$1,000 payment. But consider the savings of a 15-year loan: $99,042. That’s the difference between interest payments on a 15-year loan ($55,153) and a 30-year loan ($154,195).
Still, a monthly payment of an additional $434 can be painful. So what can you do? How about holding off on buying a new car, going with the cheapest cable TV package, eating out less? Sniff around for savings.
Consider a smaller or less expensive home. Do you really need all that space? Do you need a showroom-style living room that nobody ever sits in?
One argument in favor of a 30-year loan is that “most people move within 10 years.” Sure, but with the 15-year loan, after seven years of payments, the remaining principal is $119,113; with a 30-year loan, it’s $173,097. That’s a huge difference.
Here’s the math: With the 15-year loan, the first payment comprises $563 in interest and $855 in principal. With the 30-year loan, it’s $708 and $276, respectively. You’re quickly building up equity with the 15-year loan, while the 30-year loan has you treading water early on.
One more word of advice: When buying a house, don’t rely on the lender or real estate agent to estimate your annual costs for taxes and insurance. They just want to get the deal done. Make a personal visit to the city or county office to request a tax estimate. Then call an insurance agent for a price quote. Those additional payments can make or break a budget.
I once heard a banker say, “You might as well get used to always having a car payment and always having a mortgage payment.” That is terrible advice. If you can afford a 15-year loan, do it. After it’s paid off, you may be able to leave behind the world of borrowing.
If your employer provides a 401(k) or other tax-deferred retirement savings plan, take advantage of it. Most employers offer a matching contribution, up to a certain percentage of your salary. That means a pretty hefty return on your investment during the first year. You also defer taxes on the amount you contribute, lowering your tax bill. Plus, you avoid the temptation of having the money pass through your hands on the way to the retirement account.
The annual contribution limit for 401(k) and similar plans is $17,500. However, if you are 50 years old, the IRS allows an additional “catch-up” contribution of $5,500, totaling $23,000. Those are large figures, but a good way to get close to the limit is to increase your annual contribution by a small amount each year until you get there. It will be painful to sock away so much for retirement, but you won’t regret it.
Many important aspects of 401(k) investing are covered in how to invest for retirement.
You’ve probably seen articles discussing the 10 percent average annual return for the stock market over the past century. That can really add up over time, although market performance can, and will, vary wildly from year to year. For example, an investment with a 10 percent annual return over 20 years will multiply nearly seven-fold.
And no matter how well the stock market does, your contributions have fat returns during the first year because of the employer match. Let’s say, for example, that you earn $50,000 a year, and your employer offers a 5 percent match, so you decide to contribute 5 percent to take full advantage of that generosity.
If the market holds true to its 10 percent average long-term performance, your one-time $2,500 contribution will grow to $16,819 after 20 years. Not bad. But because your employer matches your $2,500 contribution, your return the first year is 100 percent. So your one-time 2,500 contribution, factoring in the match, grows to $33,637 over 20 years. That illustrates the power of early contributions to a retirement plan. If you start early and increase your contributions over a number of years to hit the maximum, your 401(k) can swell enormously.
One of the saddest trends is that only about four out of 10 workers under age 25 contribute to retirement plans, while only six out of 10 workers ages 25-34 make contributions. For more on this phenomenon and on the remarkable advantages of starting your retirement savings early, see major retirement savings mistakes — by millennials.
Andrea Coombes is a personal-finance writer and editor in San Francisco. She's on Twitter @andreacoombes. This article originally appeared on MarketWatch.com and is reprinted by permission from Marketwatch.com, ©2014 Dow Jones & Co. Inc. All rights reserved.