Retirement Savings Question #1 – Is my retirement savings plan appropriately balanced with the other financial priorities I have?
One of the most common questions I get asked is ‘how do I balance all of these financial priorities at the same time?’
This is a valid question. After all, many pharmacists are dealing with several competing priorities and the stress of trying to balance them all is overwhelming. These priorities include paying off debt (whether that be student loans, car payments, and/or credit cards), trying to build an emergency fund, and saving for retirement.
As I look back on the journey my wife (Jess) and I took to pay off $200K in debt, trying to do too many things at once was the biggest obstacle in our path to financial freedom. Shortly after I finished residency, we had well beyond six-figures in student loan debt, a mortgage, and two car payments. All the while, we were feeling the pressure to save for retirement, update our house and begin saving for our kids education. Sound familiar?
So, where should you start?
I firmly believe you must have a solid foundation in place for which you can build the rest of your financial plan upon (including retirement savings). This foundation includes four building blocks: (1) having 3-6 months of expenses saved in an emergency fund; (2) having a zero-based budget in place that reflects your financial goals; (3) having a plan and timeline for paying off your debt and (4) having basic insurance coverage in place. I covered these four areas in detail in a two part series I recently published on the blog titled “4 Building Blocks to a Successful Financial Future.” Here are the links to Part 1 and Part 2.
If you are looking for a step wise approach to manage your personal finances that clearly outlines which order to take these steps, check out a recent article I wrote titled “Two Paths to Financial Freedom: Which One Are You Going to Take?”
Retirement Savings Question #2 – Is the amount I am saving towards retirement going to be enough?
The million-dollar question. Literally. How much do I need to save for retirement and am I going to meet that goal?
For some reason, we often refer to retirement as if it were a mystical date in the future, out of our control and that may or may not become reality. I’m guilty of this myself. The reality is that saving for the future is not a mystery. It is simply setting a goal and putting a plan in place to achieve that goal.
So what is the magic number for retirement? $1 million? $3 million? $5 million? More?
There are several variables we need to account for to determine the ‘magic number.’
First, how many years will your savings need to last? Basically, we are talking about the difference between the age at which you will die and the age you plan to retire. Morbid, right? To calculate this number, you could use your life expectancy as determined by the Social Security calculator or you could choose an age beyond that to minimize the chance that you will outlive your savings.
For example, the life expectancy calculator gives me a life expectancy of 82 years. Let’s say I want to retire at 65. If I use the life expectancy calculator to calculate my retirement number, I need to have savings long enough to last me for 17 years after I retire. If instead I wanted to have a lower likelihood of outliving my savings, I could use a projected death age of 95, which would require 30 years where I would draw from savings. This of course would require a much bigger nest egg.
Second, what is the desired age at which you would like to be in a position to choose whether or not you are working? This doesn’t mean you necessarily will stop working at this age. Rather, you will be in a position to make that choice.
Third, what percentage of your current income (adjusted for inflation), do you think you will need to live each year in retirement? 80%? 100%? 120%? Often you will hear that a lower percentage of your income (such as 80%) is reasonable to have during retirement with the assumption that expenses will be higher during one’s working career (e.g., kids, house payment, etc.) than they are during retirement. If you have visions of doing lots of travel and other expensive activities during retirement, you may want to err on the side of assuming you will need 100% or more of your current income during retirement.
Fourth, what rate of return do you assume you will have on your investments pre- and post-retirement? While some of this is out of our control based on the volatility that comes along with investing, a projection can be made based on how conservative (assumed lower %) or how aggressive (assumed higher %) you may be in your investment approach. In addition, the assumed rate of return can be significantly impacted by the fees incurred based on the choices you make with your investments (e.g., advisor fees, fund fees).
Fifth, what do you anticipate the rate of inflation will be over your working career? While low in recent years, historically it has been approximately 3% per year. Inflation is real and is one of the reasons you should be investing your money for retirement rather than letting it sit in a savings account.
Sixth, do you anticipate you will have salary increases throughout your working career? If so, what percentage of your income, on average, do you assume those to be? Many (not all) companies will give cost of living adjustments in salary essentially accounting for inflation. If you anticipate you will have raises that are greater than cost of living adjustments (e.g., promotion), you could assume some percentage greater than 3%.
Seventh, do you anticipate receiving any social security benefits? How about any type of pension plan? To be conservative, I would recommend assuming you will not receive social security benefits and if you have them at the time of retirement that will be a bonus! Regarding the pension plan, not many exist anymore but you may be one of the lucky few out there and should account for this when doing your calculations.
Let’s walk through one example together showing how these variables impact the retirement number. Then, you can do the same on your own using a nest egg calculator such as the one at Bankrate.
Let’s assume we have a 40-year-old pharmacist, Jonny, who has $200,000 saved for retirement to date. According to the Social Security Administration web site, Jonny has a life expectancy of 82 years. He has a desire to reach financial independence at the age of 65. Therefore, we know that he has 25 years left to work from now and can expect to life 17 years beyond his desired age of reaching financial independence. For the assumptions for Jonny, let’s make it simple by choosing an average rate of return of 6% during his working years and that he desires to have 100% of his current income available during retirement. This portfolio includes a mixture of stocks and bonds invested in various mutual funds. When he turns 65, let’s assume he moves his investments around into a portfolio that is more conservative earning approximately 3% growth per year.
We can now use the aforementioned variables to determine how much money he should have at the age of 65 to last until his death if he chooses not to work beyond that point.
Here is how it would pan out for Jonny:
Holy cow! Jonny needs to save $5,718 per month to reach this goal! I don’t know about you, but that seems like a lot of money. A crazy amount of money in fact since it isn’t too far off from this pharmacist’s entire take home pay. Now, if he were to have a solid employer retirement plan with a good employer match, that might lessen that blow to some degree in terms of what Jonny has to contribute himself. Regardless, let’s all agree this isn’t a realistic situation for the vast majority of pharmacists.
So how would this look differently if we changed a few variables to make this a bit more realistic? As one example, if we change the age to reach financial independence to 70 and the desired percent income during retirement to 80% while leaving all other variables constant, Jonny would then ‘only’ need to save $2,030 per month to reach a total nest egg of $2.9 million. At $2,030 per month, we are now getting closer to a reasonable amount to save for retirement (20% of gross income) while balancing other priorities.
Remember, this was a fairly conservative calculation that assumed Jonny’s raises throughout the remaining 25 years he is planning to work would not outpace inflation. Also, remember, we assumed he would need 100% of his adjusted-inflation income at the age of 65 (likely assuming he never works again). And last, we assumed he would receive no social security benefits. On the flip side, Jonny could live much longer than 82 and therefore need much more in savings.
The beautiful thing is that once your retirement number is based on informed projections using the variables above, you can start to put a plan in place NOW that will put you on track to achieve that goal.
Retirement Savings Question #3 – How should I balance saving in a 401(k)/403(b) versus saving in a Roth IRA or other investment vehicles?
So, where should you start with retirement savings? I’m guessing most reading this article have the luxury of saving within an employer-sponsored retirement plan (such as a 401k or 403b) whereas others that are self-employed do not.
Note: The steps outlined below may or may not be most appropriate for you depending on your personal financial situation. You should consult a licensed financial advisor with further questions before making any decisions.
For those that have an employer-sponsored option (e.g., 401k or 403b) available to them, the following order should be considered.
- If your employer offers any type of match in an employer sponsored retirement plan (e.g., 401k or 403b), take it. It is 100% free money. Depending on your employer offerings, you may be able to choose from an option that defers paying taxes on your contributions (traditional 401k) or an option that defers paying taxes on your withdrawals (Roth 401k).
- Max out a Roth IRA ($5,500 limit per person in 2016) for you and your spouse (if applicable) if you meet the income eligibility requirements. If your household income prevents you from contributing to a Roth IRA, you should see if you could take advantage of a backdoor Roth IRA.
- Go back to your employer-sponsored plan (e.g., 401k, 403b) and put further contributions until steps 1-3 combined match your goal for retirement savings (see calculation completed in question #2!)
- Unless you are making a TON of money, want to retire very early and/or have a very aggressive savings goal, these three steps should get you to your monthly savings goal. If that is not the case or you desire to save beyond 20%, you could seek additional options to meet that goal including taxable investing accounts (e.g., after tax pay where you purchase investments such as a mutual fund that is not within a retirement account), annuities, cash-value life insurance, and real-estate investments to name a few. Annuities and cash-value life insurance should be explored very carefully as they can be laden with fees, are often sold with high commissions and may or may not be in your best to help you achieve your financial goals.
For those that are self-employed and/or do not have an employer-sponsored option available to them, the following order of savings for retirement should be considered:
- Max out a Roth IRA ($5,500 limit per person in 2016) for you and your spouse (if applicable) if you meet the income eligibility requirements. If your household income prevents you from contributing to a Roth IRA, you should see if you could take advantage of a backdoor Roth IRA on your own.
- If you work for yourself and it is only you, establish a Simplified Employee Pension Individual Retirement Arrangement (SEP IRA) or individual 401(k). If you have employees, you would consider a Savings Incentive Match Plan for Employees (SIMPLE) IRA. There are advantages and disadvantages to each retirement option when you are self-employed and it is worth learning about each of these further.
- Similar to those that have an employer retirement option available to them, if you are still looking for options to save more per month to meet your retirement goal, you can seek (carefully and skeptically) alternative options at this point (e.g., annuities, cash value life insurance, etc.)
Personally, I like to have a balance of retirement savings that are tax-advantaged on the contributions (e.g., 401k whether through an employer or self-funded) and others in a vehicle that are growing tax-free (e.g., Roth IRA). Why is that the case? The big question to answer (if you could) to help determine whether you should save more in an account where you pay taxes on your contributions but the money grows tax free (e.g., Roth IRA) versus an account where you don’t pay taxes on your contributions but will on the distributions (e.g., 401k or 403b) depends upon your income tax rate today versus your projected income tax rate at retirement. There are lots of opinions out there as to whether income tax rates may go up or down in the future but the reality is we do not know and I think there is wisdom in having a balance between the two.
It is important to remember that the vehicles noted above (401k, 403b, Roth IRA, etc.) are just that, vehicles. They are not your actual investments. Within those vehicles, you will have to select your investments. There is a common mistake I see that everyone should be aware of. Often someone will get so excited that they are saving 15-20% of their income in the right vehicles but they then forget to carefully select the individual investments (e.g., mutual funds) within those vehicles. If your hard earned money is going to be put away for retirement, it is worth this extra step to make sure that you are selecting the best options that match your long-term goals.
In addition to choosing the right vehicle for savings (e.g., 401(k), Roth IRA, etc.) you need to think about the investing strategy that you will use. Three main questions you should ask yourself about your investment strategy (whether that be in a 401(k), Roth IRA or some other savings vehicle).
- Based on my risk tolerance, goals and time to retirement, have I intentionally thought through my asset allocation? In short, this is the distribution of your money between various asset classes (e.g., 60% stocks, 30% bonds, 10% cash equivalents).
- Am I rebalancing my portfolio on a regular basis to ensure that the asset allocation has remained in check? For example, if you have determined that your ideal distribution for this point in your career is 60% stocks, 30% bonds and 10% cash equivalents, as those investments wax and wane over time (with hopefully more waxing than waning), you may see a shift in your asset allocation that doesn’t match your intended distribution (i.e., 70% stocks, 25% bonds and 5% cash equivalents). Rebalancing will bring you back to you desired allocation.
- Do I have a diversified portfolio of investments that have a strong track record of performance with reasonable fees? You might be wondering ‘how is this different than asset allocation?’ Well, let’s say you have a desired asset allocation of 60% stocks, 30% bonds and 10% cash equivalents but your 60% of stocks was in one or two single companies (i.e., Coca-Cola, Wal-Mart), we would say that is not a diversified portfolio. Whether it be a 401(k), Roth IRA or some other investment vehicle, you should consider a wide variety of funds that diversify your portfolio to avoid any catastrophic damage in the event of one company going south.
Those that win financially in the long run can visualize the future and act today, despite having competing financial responsibilities. They can get rid of debt, cut expenses and/or earn additional income to free up cash each month to save for the future. I have talked with too many pharmacists that say they feel like they are living paycheck to paycheck despite making a six-figure salary. Whether living paycheck to paycheck is a result of too much debt or having an expensive lifestyle, something has to give if you want to be successful in achieving your long-term savings goals.