How to develop a comprehensive retirement savings strategy.
In this topic, you'll learn:
Making the decision to save for retirement is a great first step. Then you have to form a comprehensive strategy that sets retirement goals and determines your overall investment plan.
Determine Retirement Goals
How much money will you need to live comfortably in retirement is a question only you can answer. A common approach is to estimate your income from Social Security and any pension plans, and then calculate the gap between what you'll have and what you'll need. But as we learned in the "Saving for Retirement" topic, Social Security is currently headed for challenges in the coming decades that could result in a reduction benefits. A more conservative approach is to assume that you will be 100% responsible for your own income in retirement. Any other funds will then be a bonus.
A reasonable financial goal for retirement could be to save enough to cover your income needs for at least 30 years after retirement, most likely spending a combination of savings and any investment returns they generate. When approaching retirement, many people shift toward more conservative investments - such as CDs or money market accounts - that prioritize stability over growth. These options generally carry lower risk than stocks, though they're not entirely without risk (for example, returns may not keep pace with inflation and money market funds aren't federally insured).
Savings Goal Example
For someone living a modest lifestyle with minimal debt, a goal of $1,000,000 or $2,000,000 may be enough to provide a comfortable lifestyle. For example, a hypothetical $1,500,000 in savings earning an assumed 5% annual return could potentially generate approximately $75,000 per year in income. Keep in mind that interest rates do vary, so there's no guarantee that a consistent return of 5% is always possible.
But keep in mind that these figures are in today's dollars - prices will most likely increase due to inflation while you're saving. So a $75,000 annual income in 20 or 30 years may not be the same as a $75,000 income today. For example, at an inflation rate of 3%, $1,000,000 in savings in 30 years would have the buying power of around $400,000 today.
To increase monthly income, you may choose to withdraw some of the principal in addition to the interest. For example, with a 30-year withdrawal window and a $1,000,000 principal as a hypothetical, spreading it evenly across 360 months (30 years) would equal roughly $2,800 per month - but your actual figures will depend on your balance, investment returns, taxes, and other factors. Of course, the more principal that's withdrawn, the lower the interest paid.
Please keep in mind that the savings goals mentioned here are not appropriate for every person or situation. Your needs may be less or more.
Setting Your Course
In the example above, we set an arbitrary goal of $1,000,000 to $2,000,000 saved by retirement. Now that we have a goal, the question is how to get there and what investment risks are acceptable in reaching that goal.
Your investment plan is tied directly to the amount of risk you are willing to take with your savings. At one extreme, you may want to completely avoid risk by investing in very safe investments - bank CDs, money market fund, or U.S. Treasury savings bonds. The problem with a no risk strategy is that your potential rewards are limited by the lack of risk. In other words, if you saved equal installments each year over your working life (let's say, 40 years), that's an annual savings rate of nearly $1,000 per month at an average interest rate of 4% to reach a $1,000,000 goal.
Saving $1,000 per month is simply not an option for many, so people seek to make higher returns by investing in stocks. For example, based on historical stock market averages of around 8% per year, someone investing $200 per month over several decades could hypothetically accumulate a significant amount - around $1,000,000 or so. But remember that the historical average return doesn't guarantee your average return - investing in stocks does involve the risk of lower returns (or loss) and other factors like investment fees and taxes.
Let's take a moment to explore how "historical average" returns work in the real world. While the average figure can seem like it's a practically guaranteed, it's not - some years may offer returns greater than the average and other years may have a negative return. And even for those with longer-term time horizons, stocks don't always offer the best return. For example, in the decade between 2000 and 2010, those investing in a fund of the 500 largest US stocks (the S&P 500 index) would have actually lost 25% of their investment, meaning that those in the safest investments would have earned more. On the other hand, the same group of stocks increased by over 400% in the decade between 1990 and 2000, far outpacing the gains of safer investments.
In other words, historical returns aren't guaranteed to be your returns. While the past may be a useful guide, nothing can predict the future.
Putting it all Together
Because of the unpredictability of non-cash investments, a common strategy in retirement planning is asset allocation - dividing savings between more conservative investments and those with higher growth potential. The right mix depends on your timeline, risk tolerance, and financial situation. For example, a person just starting their career with a lifetime of earnings ahead may choose an aggressive plan by allocating 75% or more of their total investment in stocks. A person in mid-career may choose a more balanced asset allocation by putting half of their portfolio in stocks and divide the rest between cash and bonds. A person approaching retirement with the goal of preserving capital may choose a conservative approach, with most of their portfolio invested in cash and bonds, with a small fraction in stocks.
By diversifying your investment portfolio, you're taking appropriate risks based on the number of years before retirement (a financial advisor can help you think through what makes sense for you).
As you can see, reaching a financial goal for retirement isn't quite as easy as simply investing $200 per month for 43 years. Your asset allocation will change over time - ideally taking advantage of the higher returns made possible by increased risk, but never endangering your financial security as you approach retirement. One major benefit to continued employment is increased earning power, so many people save more money per month as they approach retirement and in order to reduce their financial risks.
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