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Once you have completed Level I (Tackle Bad Debt) in the game of Financial Freedom, move on to Level II – Retirement Planning. There are a number of things to consider when designing your pension plan successfully. At this stage we only cover the accumulation portion of pension planning, not the distribution phase (which happens when you retire). When creating your retirement plan, start with three main factors: Determine your goals, the number of years remaining until retirement, and your risk tolerance. The goal of this initial process is to establish the average glide path of how contributions and appreciation add up to enough money that you can convert into income upon retirement.
When I opened a retirement account it was 1998 and I believe Roth IRAs had only just been formed. So I went through the whole process with a financial advisor who was also my neighbor. I wanted to retire at 65, I wanted $ 3 million, and I was high risk tolerance. I’ve always assumed that any chance of big win requires high risk. I don’t think so anymore! When the “dotcom” bubble burst in 2000, I had a new sense of my “high risk tolerance”. After paying all of the brokerage fees, I’ve lost about 50% of my investment this year. Because of this loss, I was forced to re-evaluate, which meant high risk tolerance. Since then, I’ve learned that you don’t have to take high risk to get good, consistent returns. In fact, it’s probably better not to.
Many people don’t seem to get satisfactory answers to these 3 planning questions. So I would say that the main point in determining your goal, time horizon, and risk tolerance is determining the asset allocation of your portfolio. Your asset allocation is the percentage mix of different asset classes (like stocks, bonds, and real estate) that you target. Higher risk tolerances enable higher volatility. Since stocks are more volatile than real estate and bonds, a higher risk tolerance would build a portfolio with a higher equity component. Lower risk tolerances are intended to reduce volatility and are therefore aimed at more fixed-income securities in the asset allocation.
How does asset allocation work? It works two ways. One option is diversification. Because asset classes react differently to the changing environment, diversification over time leads to better results with less volatility. Why this? All investments are influenced by 4 main factors:
1) Raw material prices as input prices, especially oil,
2) Interest rates as borrowing costs,
3) Inflation (or deflation) as a combination of federal policy, monetary policy and general pricing, and finally
4) the economy in terms of growth (business and economy).
Investments are influenced by the nominal numbers for each of these 4 factors as well as the rate of change. For example, you can have low interest rates, but if those interest rates suddenly rise rapidly, the market will devalue that change. The rate of change can have a major impact on market pricing and volatility. Remember, the ultimate goal is that the market is a future discount to profits, and any big change in any of these four areas will have a big impact on the calculation.
The second way that asset allocation works is through “realignment”. The realignment enables a systematic process of buying low and selling high. If you rebalance your wealth at set times during the year, such as twice a year, you can sell the asset classes that have grown above their target allocation percentage and buy asset classes that have fallen below their target asset allocation. This provides a process that automatically and systematically buys low and sells high.
Why are we talking about this now at Stage II – Establishing Retirement? I recommend finding a service that will do all of this for you as cheaply as possible. I recommend checking out the Robo-Advisors – WealthFront, Betterment, or Personal Capital. These companies guide you through the planning questions, set a risk tolerance number from 1.0 to 10.0, and then set up an asset mix based on your profile. They allow you to set up automatic posts and they will do the redistribution on a set schedule. The important point is to have all of this in an automated system so you don’t even have to think about it. You can also buy the index ETFs directly and free of charge from a broker like TDAmeritrade. They offer 100 free index ETFs. Note, however, that ETFs are not as automated as the robo-advisors. I would start with a robo advisor account and later tweak and improve it as you start to improve in investment skills.
So, to get to Level II, you need to set up a retirement account and automatically deposit 10% of your income. In general, I’d stay away from the company’s 401k plans unless they offer a match. If they offer a match then it’s free money and you can start Level II by setting up your 401k, but only up to what the company can match. Why? Because 401k plans have a lot of hidden fees and are quite expensive to manage. Most of the people who get rich in the 401k country are the providers, not the participants.
Also, how do you know you are on the right path to retirement? I would use these very general statements. You want “four digits” in your 20s so one day you can hit “five digits” in your 30s. And you do this so that sometime in your 40s you can hit “six figures”. If you do, you’ll want to go into “seven digits” sometime in your 50s. And if you want extra credit, you’ll hit “eight digits” sometime in your 60s or 70s. If you are 27 years old and have $ 4,000 in your retirement account, you are on the right track. If you are 38 years old and have $ 55,000 in your retirement account, you are generally on the right track. If you are 44 years old and have $ 145,000 retired, you are on the right track.
The main point here is that you need to have a “four number” portfolio before you have a “five number” portfolio and so on. And that a bond portfolio uses the power of compound interest and a long time horizon to generate high returns. This is a very general rule that does not apply to everyone. This also does not allow skipping the “Objectives” section when creating a risk and investment profile. It should be used as a very general rule of thumb. I’ll give another rule of thumb in the following articles. For now, I hope you found this point somewhat helpful and enlightening in order to win at Level II of the game of financial freedom – setting up a retirement account and investing process.
So are you ready to complete Level II – Setting Up a Retirement Account – and save 10 percent per year? You could do the entire Stage II in one step – set up a Wealthfront account and set up an automatic monthly contribution to a traditional or Roth IRA. OR you could set up your 401k in your company as long as there is a generous matching policy in place. OR you could set up a TDAmeritrade account, set up a monthly auto contribution, and invest with their free indexed ETFs. All of these approaches put you on your way to retirement planning. You can improve it later. The goal is to just start and then do the administration automatically.