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- As a financial planner, I see clients fall into two retirement-planning phases: the asset-accumulation phase, and the retired phase.
- In the asset-building phase, I help clients understand the power of compound interest and saving early.
- For pre-retirement and retired clients, I focus on mitigating the risks of negative returns, since many clients saw their portfolios drop in value during the last recession.
- Use Blooom to analyze your 401(k) today and see how you can grow your retirement savings »
When it comes to retirement planning, most people fall into two main phases.
This requires very specific advice and planning so that you build enough wealth to meet your goals, fund your lifestyle in retirement, and not run out of money in your lifetime.
The second phase requires a different approach, because it happens once you actually retire and need to withdraw income from your investments.
Both phases of retirement planning have the common goal of a successful retirement, but the concerns for each look very different. I have two favorite pieces of advice that I almost always give my clients, depending on what phase they fall into.
Understand the power of compound interest
When saving for retirement, most people focus heavily on the annual return of their investments. While this is important, that annual return is only one of the many factors to consider when you’re in phase one of retirement planning.
Understanding the power of compound interest will give you the motivation and drive you need to hit your retirement goals.
Compound interest empowers your portfolio by applying interest on top of your principal investment. The same interest rate (lower or higher) applies to the new balance, and the money snowball begins.
But your money can only compound if you give it time to do so. If you wait to invest, you have to rely on above-average returns to do the heavy lifting of increasing your account balances … which is a dangerous strategy, because that means taking on more risk to achieve your goals.
Young savers between the ages of 20 and 40 have as much as 45 years (assuming you retire at age 65) to let compounding go to work in an investment portfolio. A longer time horizon may allow you to take less risks and get to the same ending balance for your retirement, or higher.
How compound interest can work in the real world
I often tell a story about a set of fictional clients, Paul and Emily, to illustrate how compound interest can work for you.
Let’s imagine that both Paul and Emily invest $100 a month into a non-taxable retirement account, like an IRA, and they earn 7% on their investment, which is compounded annually.
If Paul saves $100 a month beginning at age 25 for 10 years and then stops contributing at age 35, he put a total of $12,000 into his IRA. By age 65, compound interest would help that amount grow to $126,211.
In contrast, imagine that Emily didn’t start saving until age 35 — but when she did, she saved $100 for 30 years. That means she saved for 20 more years than Paul did, but she waited 10 years longer to start.
Emily’s total contributions equaled $36,000; much more than Paul’s $12,000. But because Emily didn’t allow compound interest as much time to work for her, her account balance at age 65 would be $113,353 — $12,858 less than Paul’s ending balance, even though Paul contributed $24,000 less.
This is the power of compound interest when you give it time to take effect. Before Emily even began saving at age 35, Paul had already amassed $16,580, which was being compounded at 7%. Although Paul saved less in both years and dollar amount, he used the power of compound interest to yield a more significant return.
Mitigate the risk of negative returns
My second favorite piece of advice to give to clients is for those in phase two of their retirement planning.
As a retiree, one of the most significant risks you need to safeguard against is substantial negative returns at the beginning of retirement if you withdraw from your portfolio.
Studies show that withdrawing money from a portfolio that experienced negative returns early in your retirement will make it more likely that you’ll run out of funds faster than if you had a portfolio that yielded the same return rate — but the losses came at the end of your retirement.
Unfortunately, many retirees realized this during the Great Recession. Between December 2007 and June 2009, the S&P 500 lost over 50%. Pre-retirees less than 10 years away from retirement didn’t fare that much better.
The average person inside of a 2000-2010 Target Date fund was down over 20%. Investors who held shares from the Oppenheimer Transition 2010 fund would have seen losses of more than 40%.
If your portfolio was down 40% during your first year in retirement and you didn’t make significant changes to your withdrawal amounts, you greatly increased your chances of running out of money in your lifetime due to this sequence of returns.
Thankfully, retirees can use various strategies to mitigate this particular investment risk.
Some of those techniques are lowering your portfolio withdrawal rate, using your home’s equity via a reverse mortgage, creating a bond ladder strategy, and implementing a bucket strategy within your portfolio.
My favorite approach, however, might be our firm’s proprietary strategy. We call it the “Living Asset Allocation” approach, and it is a retirement income approach that uses one’s personalized cash flow needs in conjunction with a dynamic bucket strategy.
By following these two pieces of retirement advice, you are sure to weather most retirement planning storms at any stage.
Malik S. Lee, CFP, CAP, APMA, is a financial expert with nearly two decades of experience and is the founder of Felton & Peel Wealth Management.
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