Strategies For Retirement Investments: A 15-Year Plan

If you're 15 years away from retirement, it's time to start thinking about your retirement goals and how to achieve them. Here are some steps to help you prepare:

- Create a retirement budget: Calculate your expected expenses during retirement, including basic living costs, debt payments, and entertainment. Compare this to your projected retirement income to identify any funding gaps.

- Maximize your contributions: If you're in your 40s or 50s, consider increasing your retirement savings rate. The general rule of thumb is to save 10% of your income in your 20s, 20% in your 30s, and 30% in your 40s. Aim to contribute at least 15% of your annual income, including any employer match, to reach your retirement goals.

- Start estate planning: Have financial and health conversations with your family, and consider creating a will, exploring pre-payment of funeral expenses, and setting up a trust for loved ones.

- Review your portfolio's risk exposure: Assess your risk tolerance and time horizon. Some investors reduce their exposure to stocks as they get older, while others maintain or increase their equity investments due to rising life expectancies and the low-interest-rate environment.

- Diversify your investments: As you near retirement, it's important to maintain a balance between growth potential and stability in your portfolio. Consider a mix of stocks, bonds, cash equivalents, and other fixed-income investments to meet your income goals and manage risk.

Creating a retirement budget

Identify Income Sources:

Start by listing all your potential income streams during retirement. This includes tax-advantaged retirement accounts (e.g., 401(k), 403(b), Roth IRA), Social Security benefits, pensions, part-time earnings, taxable investments, real estate income, and annuities. Calculate the total annual income from these sources and then divide by 12 to get your monthly income estimate.

Calculate Expenses:

Identify your expenses by reviewing bank statements, credit card statements, and receipts from the past 6-12 months. Separate your expenses into fixed and variable costs. Fixed expenses include rent, mortgage, car payments, insurance, and utility bills, while variable expenses cover groceries, dining out, clothing, entertainment, gas, repairs, and medical bills.

Compare Income and Expenses:

Now that you know your expected income and expenses, it's time to compare the two. If there's a gap, consider ways to increase your income or reduce costs. For instance, you might work a little longer, delay claiming Social Security, boost retirement contributions, or downsize your living arrangements.

Plan for Healthcare Costs:

Healthcare costs tend to increase during retirement, so it's essential to plan accordingly. Medicare will cover some expenses once you turn 65, but not everything. Consider using a health savings account (HSA) before enrolling in Medicare, and look into long-term care insurance to cover expenses that Medicare doesn't.

Create a Zero-Based Budget:

Create a budget that allocates all your income to specific expenses, so nothing is left unaccounted for. This ensures that every dollar is spent, saved, or given according to your plan.

Track Seasonal and Non-Essential Expenses:

In addition to your monthly expenses, consider seasonal costs, such as gifts for special occasions, and non-essential expenses like subscription services, hobbies, and travel.

Establish Sinking Funds:

Set up dedicated savings funds for specific goals, such as vacations or large purchases. This ensures that you have the necessary funds when you need them without disrupting your regular budget.

Test and Adjust Your Budget:

Your retirement budget isn't set in stone. Periodically review and adjust it as your circumstances change. Test out your budget before retiring to identify areas that need tweaking.

Seek Professional Advice:

Remember, retirement budgeting is about ensuring you have the funds to spend on the things you truly want in retirement, enabling you to enjoy your golden years to the fullest.

Maximising contributions

Start Saving Early

The earlier you start saving, the more time your savings have to grow and compound. Even if you can only afford to save a small amount each month, starting early will make a significant difference in the long run.

Contribute to Your 401(k) or Workplace Retirement Plan

If your employer offers a 401(k) or similar workplace retirement plan, this can be a great place to start saving for retirement. Contributions to traditional 401(k) plans are often made with pre-tax dollars, so you won't pay federal income taxes on those contributions. Roth 401(k) plans, on the other hand, are made with after-tax dollars, but you won't pay any taxes on withdrawals during retirement.

Take Advantage of Your Employer's Company Match

Many employers offer to match a portion of their employees' contributions to their retirement plans. This is essentially "free money", so it's important to contribute enough to receive the full amount of the company match. For example, if your employer matches 100% of your contributions up to 3% of your salary, and 50% of your contributions on an additional 2%, you would need to contribute 5% of your salary to receive the full 9% match.

Deal with High-Interest Debt

High-interest debt, such as credit card balances and student loans, can significantly impact your ability to save for retirement. Focus on paying off these debts first, as the interest rates on these loans often far exceed what you're likely to earn through your investments.

Contribute to a Health Savings Account (HSA)

A Health Savings Account (HSA) is a great way to save for healthcare costs during retirement. HSAs offer tax benefits, including tax-deductible contributions, tax-free withdrawals for medical expenses, and tax-deferred growth on your investments. Plus, once you reach age 65, you can withdraw money from your HSA for any reason, although you'll have to pay taxes on non-medical withdrawals.

Contribute to an Individual Retirement Account (IRA)

In addition to your workplace retirement plan, you can also contribute to an Individual Retirement Account (IRA). IRAs typically offer a wider range of investment options than 401(k) plans, including individual stocks, bonds, ETFs, and mutual funds. There are different types of IRAs to choose from, including traditional IRAs and Roth IRAs, each with its own tax advantages.

Add After-Tax Money to Your 401(k)

If you've already maxed out your pre-tax contributions to your 401(k), you may be able to add after-tax contributions. This allows you to contribute beyond the individual limit and take advantage of compound interest on your savings.

Consult a Financial Advisor

If you're unsure about how to maximise your retirement contributions or how to manage your investment portfolio, consider consulting a financial advisor. A certified financial planner or investment advisor can provide personalised advice and help you build a comprehensive financial plan that aligns with your goals.

Estate planning

• Have a will in place: Without a will, your assets will go through the probate process, which can be confusing and time-consuming for your loved ones.
• Review and update beneficiaries: If you have an IRA or employer plan account, such as a 401(k), review the designated beneficiaries and make sure they reflect your current wishes.
• Create a comprehensive financial information packet: Gather all your financial information in one place and ensure your loved ones know where to find it.
• Consider a trust: A trust can give you more control over your assets, allow you to appoint a corporate trustee, provide privacy, and potentially reduce taxes on your estate.
• Plan for long-term care: Consider long-term care insurance and advance directives for your medical care, including a living will and a healthcare proxy.
• Consult professionals: Estate planning can be complex, so it is advisable to seek help from a financial adviser and a lawyer when creating your estate plan.
• Roth IRA: This offers tax advantages, flexibility, and the potential for tax-free withdrawals in retirement.
• Traditional IRA: Provides tax benefits and a wide range of investment options but withdrawals before retirement may result in taxes and penalties.
• 401(k): Allows you to save for retirement with pre-tax wages and offers tax-free growth. Some employers may also offer matching contributions.
• Bonds: Offer a steady income stream and can be a good option in the current interest rate environment.
• Income-producing equities: Some stocks pay dividends and can provide a regular stream of income, but there is a risk of fluctuation in stock prices.

Reviewing portfolio risk exposure

When reviewing a portfolio's risk exposure, it's important to understand that the proportion of a portfolio invested in equities is the key factor in determining its risk profile. Most sources consider a low-risk portfolio to be made up of 15-40% equities, with medium risk ranging from 40-60% and high risk being generally 70% and above. The remainder of the portfolio is typically made up of lower-risk asset classes such as bonds, money market funds, property funds, and cash.

There are several ways to assess a portfolio's risk exposure and how it impacts the sources of return within that portfolio. Here are some methods and factors to consider:

• Modern Portfolio Theory (MPT): This theory assesses the maximum expected portfolio return for a given amount of portfolio risk. It helps in constructing an optimal portfolio based on asset allocation, diversification, and rebalancing. Diversification can reduce risk, and optimal diversification is achieved by holding multiple uncorrelated assets.
• Alpha and Beta Ratios: These statistical metrics are used in MPT to determine the risk/reward profile of investment securities. Alpha measures the performance of a portfolio compared to a benchmark index, while beta measures volatility compared to a benchmark index.
• Capital Asset Pricing Model (CAPM): CAPM is an equilibrium theory that analyses the relationship between risk and expected return. It helps investors measure the risk and expected return of an investment to price the asset appropriately, taking into account the time value of money and risk.
• Standard Deviation: This statistic quantifies the variation from the average return of a dataset. In finance, it measures the volatility of an investment by comparing it to the historical returns of the security. High standard deviations indicate volatility, while lower ones are associated with stable assets.
• Sharpe Ratio: This ratio measures the expected excess return of an investment relative to its volatility. It helps determine the additional return an investor can receive by holding riskier assets. A Sharpe ratio of one or greater is considered favourable.
• Efficient Frontier: Introduced by Harry Markowitz in 1952, the efficient frontier identifies an optimal level of diversification and asset allocation given the intrinsic risks of a portfolio. It aims to minimise an investor's exposure to risk by constructing a set of ideal portfolios offering the highest expected return for a specific risk level.
• Value at Risk (VaR): VaR is a simple way to measure risk by determining the maximum loss that cannot be exceeded at a given confidence level. It provides investors with a worst-case scenario analysis.
• Risk Tolerance and Time Horizon: Understanding your risk tolerance and time horizon is crucial when selecting investment options for retirement. Generally, younger investors can tolerate more risk but have less income to invest, while those closer to retirement may have more funds to invest but less time to recover from losses.
• Global Risk Model: This tool, provided by Morningstar, allows for comparisons across portfolios and benchmarks on a standardised, objective basis. It enables users to create custom market scenarios, perform what-if analyses on market movements, and gauge their portfolio's exposure to various factors.
• Valuation Risk: The Global Risk Model uses the valuation factor to evaluate how cheap or expensive a portfolio is compared to a fair value estimate. This helps determine if a portfolio is overvalued or undervalued.
• Competitive Advantages: When considering a portfolio's risk exposure, it's important to assess the competitive advantages of the companies in which the portfolio is invested. The economic moat rating measures the strength and sustainability of a company's competitive advantages.
• Size Factor: The size factor considers the market capitalisation of stocks in a fund's portfolio to identify where they fall in the market-cap ladder. This factor helps determine if a portfolio is focused on small-cap, mid-cap, or large-cap stocks.

By understanding these factors and utilising available tools and models, investors can make informed decisions about their portfolio's risk exposure and adjust their investment strategies accordingly.

Understanding asset allocation

• Time Horizon: Consider when you plan to use the money in your portfolio. If you're investing for retirement, your time horizon is long-term, and you may be comfortable taking on more risk. As you approach retirement, you may want to adjust your asset allocation to reduce risk and focus more on income-generating investments.
• Goals: What are your investment goals? Are you investing for retirement, saving for a first home, or funding your child's education? Your goals will influence your asset allocation. For example, if you're primarily investing for retirement, you may have a higher allocation of stocks during your working years to maximize growth potential.
• Investment Objective: Are you seeking capital growth or income generation from your investments? This will impact your asset allocation. For instance, if you prioritize income, you may allocate more to bonds and dividend-paying stocks.
• Risk Tolerance: How comfortable are you with market fluctuations and risk? If you're risk-averse, you may prefer a more conservative asset allocation with a higher proportion of bonds and cash. If you're comfortable with risk, you may tilt your portfolio towards stocks and other growth-oriented investments.
• Current and Future Income Sources: Consider your current income sources and how they might change during retirement. For example, if you're still working, you may have a higher allocation of stocks, while retirees may prefer more stable investments like bonds and cash to meet daily expenses.
• Investor Type: Your investor type, whether aggressive, moderate, or conservative, will influence your asset allocation. Aggressive investors are typically comfortable with higher-risk investments and have a longer time horizon. Moderate investors may take on some risk but also seek a balance between growth and income. Conservative investors prioritize capital preservation and often have a shorter time horizon.
• Market Conditions: Keep an eye on market fluctuations and adjust your asset allocation as needed. For example, during a booming economy, you may invest more in stocks, while a cooling economy may prompt a shift towards bonds and cash.

Here's an example of how your asset allocation might change over time:

When you're younger:

• Stock funds: 80%
• Bond funds: 20%

As you approach retirement:

• Stock funds: 35%-50%
• Bond funds: 35%-50%
• Cash: 5%-30%

Remember, asset allocation is not a set-it-and-forget-it strategy. Regularly review and rebalance your portfolio to ensure it aligns with your goals, risk tolerance, and changing market conditions.

Frequently asked questions