How to invest for retirement in the United States (without relying on Social Security)

Whether one likes the concept of Social Security or not, it is clear that the US Social Security system as it stands will be unable to provide for the retirement of many who are currently working. Since the system is so very over committed, it is wise to save for retirement even if you expect Social Security to outlive you. Thankfully, the United States stock market offers outstanding returns over the long run and therefore you will be able to save enough money for a comfortable retirement.

Before saving for retirement, pay off all consumer debt (including automobiles and student loans), promise never to go in debt, and have a cash reserve of 3-6 months of expenses. You never want to put yourself in a position of having to withdraw money from a retirement account early or of borrowing money against a retirement account, since those can be extremely expensive.
Estimate how many years you are from retirement. In this article I will present calculations for those who are 10, 20, 30, 40 and 50 years from retirement. The sooner you start, the better, so start today.
Calculate your desired nest egg size.

Over the history of the stock market, the average annual return has been about 12% over the long run (and that includes periods such as the Great Depression). Inflation was about 3.3% from 1913 to 2007. Therefore, a reasonable expectation would be that your money will grow about 12%-3.3%=8.7% faster than inflation. For the purpose of this article, we'll round down to 8% to be pessimistic. During retirement, you do not want to consume your nest egg, but rather live off the growth from your nest egg. Therefore, you want to avoid the "conventional wisdom" of moving to more "conservatives" investments such as bonds during retirement, but rather stick will stocks, which are not much more volatile than bonds, and have a much higher return.

Since you want to live off your nest egg, you'll only want to withdraw the annual growth. Since the portfolio should return about 8% adjusted for inflation, one can pull off 8% each year without long-term loss of principal. So, if you want a retirement income of $100,000, take $100,000 and divide it by .08 (which is the same as multiplying by 12.5). For the $100,000 example, that would mean your nest egg would have to be $1,250,000.
Calculate how big your nest egg will be based on how much you contribute.

Assuming that you currently have no balance in your retirement accounts, you can use the following figures to estimate the future balance of your account. We assume that you contribute a fixed amount each year and that you average 8% more than inflation.
If you retire in 10 years, the balance will be 15.65 times your annual contribution.
If you retire in 20 years, the balance will be 49.42 times your annual contribution.
If you retire in 30 years, the balance will be 122.35 times your annual contribution.
If you retire in 40 years, the balance will be 279.78 times your annual contribution.
If you retire in 50 years, the balance will be 619.67 times your annual contribution.
Calculate what percentage of your income you will need to contribute to a retirement account.
Calculate what percentage of your income you will need to contribute to a retirement account.

Remember that you will need 12.5 times your annual income in a retirement account to retire comfortably. Referring to the table above, take 12.5, divide it by the amount given, and multiply by 100% to get the percentage of your annual income that you have to contribute yearly.
Retire in 10 years: 80% of annual income
Retire in 20 years: 25% of annual income
Retire in 30 years: 10% of annual income
Retire in 40 years: 4.5% of annual income
Retire in 50 years: 2.0% of annual income

As you can see, it's unrealistic to save for retirement in just 10 years, but it's quite possible in 20 years. Although you need to save very little money if you plan to retire in 40 or 50 years, it makes sense to save 15% of your income as a minimum, and then you will retire very wealthy.
Consider what tax-advantaged accounts are available to you.

The US tax code offers various tax advantages to those saving for retirement. Your income level may disqualify you from certain tax advantages. In general, here's a good order of accounts. Not all options will be available to you, so skip over the ones that don't apply. Put the maximum in the highest priority account before moving to any further account.
1. Contribute to any 401(k) plan that has a company contribution match. If a Roth 401(k) is available, opt for that.
2. Contribute to a Roth IRA.
3. Contribute to any 401(k) that has no company contribution match or a SEP account (for self employed).
4. Contribute to a traditional IRA (unlikely to be an option if you maxed out other accounts, however).
5. Invest in a regular brokerage account (which offers no tax advantage.)
Decide on investment vehicles.

The most reasonable investment vehicles are good, strong, growth stock mutual funds that have a long track record of above-market performance. Don't invest in individual stocks for the following reasons: Enron, Worldcom, Lehman Brothers, Bear Sterns, Fannie Mae, Freddie Mac, etc. Many people had their entire retirement savings in a handful of stocks and lost it all. If you invest in good mutual funds, your investments will be spread out over hundreds or thousands of stocks, so one collapse will not be disaster.

Look for mutual funds that have been around for more than 10 years and that have a track record of 12% annual returns or greater. An easy pick that great for beginners and usually has low minimum investments are index funds, such as a fund that tracks the S&P 500 (the largest 500 publicly traded companies in the United States.)
Open an account.

If an account is available through your employer, consult the employer for details on opening an account. If you are setting up a Roth or traditional IRA, you can do it with a local mutual fund broker, or you can do it online with large companies such as Vanguard, Fidelity, TIAA-Cref, T. Rowe Price, e-Trade, etc. Many offer accounts that charge no fees.
Invest equal amounts weekly, biweekly, or monthly. Make sure the investment is automatically drafted from your checking account or deducted from your paycheck.

People are very bad at timing the market, and people who are investing their own money are even worse at timing the market. Therefore, don't try to time the market, but rather invest the same amount each week/monthly/paycheck, every time without exception. Do it in up markets and down markets.

  • Avoid listening to financial news if this will affect your investment strategy. Remember, you are investing for the long run, and all the financial news is based on short-term information, and has little or no relevance for the long term.
  • Don't believe the myth that you should move to conservative investments when you retire. This myth is only valid if you plan to consume all your retirement money during retirement. Instead, you should plan to live off the interest and income generated by your investments, and you want that to be as much as possible. Stay aggressive during retirement.
  • As with any investment, past performance in only an indication of future performance, not a guarantee. Any investment can lose value. However, investing in life-style now is certain to lose value, so don't skip retirement planning just because it might lose value.

  • Don't sell during down markets! Down markets precede up markets, and thus you will miss the times of greatest gain.
  • Don't buy insurance products or CD's for retirement. Salesmen of these products often present doomsday scenarios where the stock market collapses and your stocks would be worth nothing. If such a thing were to happen, then the insurance company or bank would also go out of business and your investment with them would be just as worthless.
  • Don't buy gold or foreign currency as an investment. Those are not investments, but merely gambles. Gold averages about the same as inflation over the long run (and can drop significantly in value, even over a short period), and foreign currency averages 0% over the long run.

Copyright 2009 by Michael Nehring