Wealth Management Group Newsletter – Spring 2013
Wealth Management Group Newsletter – Spring 2013
Getting 20-Somethings to Jump-Start Their Retirement Savings
STEVEN H. LEWIS
Whether your children (or grandchildren) are recent college graduates just starting their first job or have been employed and supporting themselves for several years, they may not be taking advantage of their employer-sponsored retirement plan. Unfortunately, for many 20-somethings, saving for retirement takes a backseat to other priorities.
While it may be difficult to get young people to focus on a retirement that may be 40 years or more away, those who get an early start on saving will be much better prepared to handle future financial challenges. To ensure your kids establish solid retirement saving habits early in their careers, consider incorporating the following topics into your own Retirement Savings 101 lesson plan.
Start Saving Now
If you can teach your kids to start saving for the future at an early age, they may someday raise a glass in your honor. That’s because young people have a built-in advantage over older investors — plenty of time.
Assuming their employer offers a matching contribution, your kids should — at a minimum — contribute enough to earn the full matching contribution from their employer. That provides a guaranteed immediate return on their investment, along with the potential for future tax-deferred growth. If they can afford to contribute more, then by all means they should do so. By saving as much as they can in the early years of their career, young adults can take full advantage of the “miracle” of compound growth.
Consider the example of a 25-year-old who sets aside $1,000 a year in a 401(k) plan and stops contributing at age 55, for a total contribution of $30,000. Assuming a 6% return compounded annually, that money would grow to more than $150,000 by age 65. In comparison, a 35-year-old who invests the same $1,000 a year for 30 years would accumulate only $83,802 by age 65. (This example is a hypothetical and isn’t intended to predict the performance of any specific investment.)
Put Savings on Autopilot
Today, some employers’ plans automatically enroll new employees in the company’s 401(k) plan. If their employer doesn’t automatically enroll them, encourage your kids to sign up as soon as they’re eligible.
In most cases, contributions from employees who are automatically enrolled are invested in a target date retirement fund* until they designate otherwise. A target date fund, also known as a lifecycle, dynamic-risk or age-based fund, invests in a mix of mutual funds that gradually becomes more conservative as the fund’s target date (usually retirement) approaches.
For example, a 22-year-old might have her contributions directed into a target date fund that “matures” in the year 2055. Because time is on its side, a fund with a 2055 target date will often allocate as much as 90% of its assets to stocks today. This allocation will include domestic, international and emerging-market stocks. (Investments in non-U.S. securities involve currency-fluctuation risk, and political or economic instability in the country in which the securities are issued can affect the value of those securities. Emerging-market securities can be highly volatile and speculative.)
The remaining 10% likely would be allocated to bonds. (Keep in mind that bonds involve varying degrees of default, market and interest rate risks, with high yield bonds being speculative.) As the target date gets closer, the fund gradually will reduce its exposure to stocks and add exposure to lower-volatility offerings, such as bonds and money market funds. Bear in mind that the principal value of the fund isn’t guaranteed at any time, including at the target date.
While target-date funds provide an easy way to build an age-appropriate asset allocation, employees generally are free to opt out and choose their own mix of funds. The key point young investors need to understand is that they typically should invest a healthy portion of their retirement savings in stocks. The road will get bumpy along the way, but with time on their side, young investors can afford to ride out the periodic market selloffs.
Share Your Wisdom (and Mistakes)
Your children may not be eagerly anticipating your unsolicited financial pearls of wisdom and may even get defensive in response to questions about their personal finances. One way around this is to share some of your own youthful financial mistakes and what you learned from them. There’s no guarantee your kids will listen and learn. But if you’re able to instill an appreciation for disciplined saving habits, both you and your kids will be better off in the long run.
* There is no assurance that a target date fund will achieve its objective of moderating risk as the fund approaches its target date. Risk of loss is present throughout the target period. Funds which invest in other mutual funds are subject not only to the risks of the target fund but also to the special risks of the underlying mutual funds. Target funds may involve fees related to both the target fund and the underlying funds. Investments in equities have been volatile historically. Investments in fixed income securities fluctuate in value in response to changes in interest rates.
Sidebar: Which Comes First? Retirement or Student Loans?
It’s increasingly common for college students to graduate with some form of debt. This leaves many wondering whether they should prioritize paying down their student loans over saving for retirement.
It’s generally advisable to enroll in an employer’s retirement savings plan as soon as possible, assuming the employer matches employee contributions, rather than making extra student loan payments. Of course, if your child’s take-home pay minus retirement contributions isn’t sufficient to meet required student loan payments and other expenses, retirement savings may have to wait.
But it may be possible to reduce expenses. Suggest your kids track their expenditures over the course of a month or two to see where their money goes. If your child can’t reduce expenses enough to start saving for retirement, his or her first raise or promotion may provide the additional income needed.
Should You Pay Off Your Mortgage Early?
If you’re contemplating paying off your mortgage early, congratulations. But just because you can retire your mortgage early, that doesn’t necessarily mean you should.
Arguments For and Against
Paying down your mortgage early can save you serious amounts of interest expense over the course of a 30-year loan. Consider what would happen if you increased your monthly payments on a $400,000 mortgage that charges 4% interest over 30 years. If you made the required monthly payment of $1,909 a month, you would pay $287,478 in interest over 30 years. But by bumping your payment up by an extra $500 each month, you’d pay off your loan in only 20 years. Better yet, you’d save $103,901 in interest expense over the term of the loan.
Looking at it this way, paying down your mortgage early seems like an obvious decision. You also, however, need to consider whether you could earn a higher return by investing that extra $500 a month elsewhere.
You may think that your return on the early mortgage payments would be 4%. But that doesn’t factor in the value of the mortgage interest tax deduction. If your marginal tax bracket is, say, 28%, this deduction can potentially save you 28% on any mortgage interest payments you make, which means you’re effectively paying only 72% (100% minus 28%) of 4%, or 2.88%.
In the not-too-distant past, you could sock your money away in an ultra-safe Treasury bond or CD and earn 2.88% or more. Today, interest rates remain at historically low levels, so the only way to earn higher yields is to invest in riskier assets, such as mutual funds that hold stocks. Over long periods of time, stocks have delivered average annual returns that are significantly higher. And, if you invest your extra cash in a tax-advantaged retirement account, you could come out well ahead in the long run.
Stocks can be highly volatile, however, so you may prefer bond funds. But bond funds aren’t risk-free either, especially with interest rates near historically low levels. If rates rise from today’s low levels, funds that invest in medium-term and long-term bonds will likely experience a decline in their net asset value.
As an alternative, you might consider a short-term bond fund. These funds typically invest in bonds that mature in three years or less. Bear in mind, however, that bond funds involve varying degrees of default, market and interest rate risks.
Short-term bonds are less sensitive to changes in interest rates, so if rates were to rise, the damage to your portfolio would be less severe. In addition, the fund’s holdings will turn over more quickly than funds that hold long-term bonds. As interest rates rise, the fund managers can reinvest the proceeds of maturing bonds into new, higher-yielding securities. That will help dampen the effect of declining bond prices. However, your initial rate of return may not be high enough to offset your return from making extra mortgage payments.
Other Questions to Consider
In addition to the potential returns you can earn on your money, there are several other questions to consider before you retire your mortgage early:
Should you consider refinancing first? With interest rates still very low, you might be able to obtain a lower rate by refinancing. This, in turn, may allow you to reduce your mortgage term while keeping your monthly payments about the same. So you’ll be able to pay off your mortgage more quickly — without taking any more money out of your pocket. After refinancing, you can reconsider making extra mortgage payments. But your lower mortgage rate will increase the likelihood that you can get a better return elsewhere.
Are you saving enough for retirement? Saving for retirement should be a higher priority than paying off your mortgage, because you won’t be able to take out a loan to pay retirement expenses. Maximizing contributions to your 401(k) plan and IRAs can reduce your taxable income and, depending on the type of accounts, accrue tax-deferred or tax-free savings you’ll need for retirement.
Do you have higher interest debts? If you’re carrying credit card debt, it’s likely that you’re paying a significantly higher interest rate on that debt than on your mortgage. Plus, credit card interest isn’t tax-deductible. So paying off your credit card debt first is probably a good idea.
Are you comfortable having more money tied up in your home? Once you’ve made a payment of principal, that money essentially becomes illiquid — you generally can access it only by selling the home or taking out a home equity loan or line of credit. If home values haven’t stabilized in your area or you anticipate a possible need for cash in the near future, you may not want to tie up more money than necessary in your home.
Seek Professional Advice
In addition to the financial benefit of substantially reducing your total interest paid, paying off your mortgage early provides the intangible benefit of peace of mind. Knowing that you own your home free and clear and that you’ll always have a roof over your head can be liberating. But, as outlined here, there are several reasons why you might want to think twice.
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