Early savings pay off later in retirement

Barbara Friedberg

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How much should you save for retirement? The true answer is that no one knows. However, Barbara Friedberg is sure of one thing — those who start their retirement planning and save early often will end up in much better shape than people who begin saving in their 40s or later. Retirement planning in your early years of life will save you from facing financial hardship during your retired years.

However, the lecturer at the Leavey School of Business at Santa Clara University and editor in chief of BarbaraFriedbergPersonalFinance.com says do not worry if you are among the procrastinators — all hope is not lost.

What is the correct amount of money that people should save for retirement on a percentage basis? Should it be 10 percent, 15 percent or 20 percent?

In general, it is best to save as much as possible and even more importantly to start as soon as you begin working. If a young adult starts her retirement planning in her 20s, she does not need to save as much as a person who starts saving in her 40s.

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For example, Jill starts investing $300 per month in a diversified all-world stock index fund at age 25. She continues to invest the same amount per month until age 65. Over the 40 years, she invested a total of $144,000 and at age 65, she amassed $770,000. Assume an average rate of return of 6.9 percent over the 40 years.

If Jill earned $45,000 at age 25, then that $3,600 per year was only 8 percent of her salary. As her salary grew, the percent of her salary invested was even less than 8 percent.

Consider Jack, who didn’t start investing until age 40. Assume Jack earned $60,000 per year and decided to save 15 percent of his salary, or $9,000 per year, for retirement. He invests in the same diversified all-world stock index fund as Jill. For simplicity’s sake, assume he continues to save $9,000 ($750 per month) until age 65. The total amount Jack invests is $225,000. At age 65, Jack’s retirement savings equal $598,025.

Jill invests less money, starts earlier than Jack and ends up with more wealth in retirement. The best retirement strategy is to start young. Start later, and you need to save a lot more than those who begin earlier.

Longevity risk — the risk of outliving your money — is a big issue for people about ready to retire. Companies now are offering their former employees a choice between a lump sum and a regular pension check. Companies hope the lump sum offer is accepted so they can offload the longevity risk. Who should bear this risk?

The companies who initially offered the pensions are under a social (and usually legal) contract to uphold their obligation.

Annuitizing part of one’s retirement funds, (combined with) Social Security, is an excellent way to guard against the potential of outliving your funds. As with the former question, there is not one correct solution for everyone. The decision whether to take a lifetime annuity or lump sum payout is complicated.

Factors to consider depend upon available investment alternatives for the lump sum payment and growth expectations of the funds. Additionally, some individuals are better off with the simplicity and guarantee of an annuity. If one is confronted with this type of decision, it’s wise to schedule an hour — or two sessions — with a fee-only financial planner to evaluate the choice.

Are insurance products such as annuities a good solution for getting a regular check in retirement? If so, what type of annuities would you recommend?

Annuities are helpful to stabilize one’s cash flow in retirement and solve the retiree’s problem of outliving her money. According to the U.S. Securities and Exchange Commission website, there are three types of annuities: fixed, indexed and variable.

I suggest purchasing an immediate fixed annuity with part of your retirement funds. In exchange for an initial payment, the recipient receives a cash flow for life, or for the combined life of purchaser and spouse. The negative aspect of these types of annuities is that if you die early, you get no refund on the initial payment. On the other side, live a really long time and you get monthly income far above the amount of your initial contribution.

Should the government get more involved in helping Americans prepare for retirement by, for example, creating an annuity on top of Social Security?

I don’t believe it is the government’s place to create additional funding options for retirement. Retirement planning is the individual’s responsibility.

How do you think the impending shortfall of Social Security should be handled? Should the cap on wages of $110,100 be lifted so that more people at higher levels of income contribute to the payroll tax?

Currently, one can receive partial Social Security benefits at age 62 and depending upon birth year, the retiree is eligible for full benefits between ages 65 and 67. With the average lifespan substantially higher than when Social Security was created, it is reasonable to raise both the age one can begin receiving retirement benefits as well as the full retirement age. (Further reading is available at Cato.org and SocialSecurity.gov.)

Inflation impacts wage growth, and the 4.2 percent tax directed toward Social Security for incomes up to $110,000 should certainly be examined. Raising the level of income subject to Social Security tax from $110,000 to $120,000 costs workers an additional $420 per year.

We would like to thank Barbara A. Friedberg, MBA, lecturer at Leavey School of Business at Santa Clara University in Santa Clara, Calif., for her insights. Questions for this interview were contributed by Barbara Whelehan, assistant managing editor for Bankrate.com.