One of the reasons that company retirement plans are so simple is that they’re set on autopilot. Once you select your payroll deduction, most people typically never think about it again. In the past, this could also be a danger; but, with the creation of target date funds, even asset allocation and rebalancing can be set to autopilot. But what about additional savings? Why is it so hard for folks to save additional money outside of their retirement nest egg? This could be future money towards retirement income or maybe additional funds to make that large purchase in a few years. Whatever the reason, most people struggle with this because it falls near the bottom of their priority list; and thus, only transpires when there is excess cash at the end of the month. Well, here’s a newsflash. There will NEVER be excess cash at the end of the month.
I often hear high income folks say things like, “With what we make, we should have more money, but we don’t.” Most of the time, this is a result of not monitoring their money (Link). There is one very simple solution that can be implemented immediately, which often makes a huge difference.
PAY YOURSELF FIRST
Let’s face it, while most Americans struggle with month to month expenses, there is another tragedy; whereby, many people make more than enough money to live, save nothing, and remain one misstep away from financial disaster.
So, here it is; a very simple solution that you can begin today, start saving for your future and put it on autopilot.
Step 1 – Open an online Vanguard account. www.Vanguard.com
While there are cheaper options, such as index funds from Schwab, I recommend this company because of the brand recognition and my love for the passive investment pioneer, John Bogle. Truth be told, we would use Vanguard as a primary custodian in our advisory firm, if we could, but independent RIAs are not allowed to use this platform; so, we stick with most of the Vanguard sector funds as a base for our investment plan. Nonetheless, what you’ll be looking to open is a basic individual investment account. If you’re married, you’ll want this to be joint with Rights of Survivorship. Basically, this means that if something happens to one of you, the other will immediately take full ownership of the account without probate or court proceedings. (Side note, you should immediately retitle all non-retirement accounts to have a beneficiary, but more on this later.)
Step 2 – Connect this account with your primary checking account.
If you are one of those people who have strange security anxieties, I can’t help you with this. I hold the opinion that, if hackers wanted to steal my information and drain my bank account, there isn’t much I could do to stop them. That is precisely why each bank is FDIC insured and investment accounts carry what is called SIPC (Securities Investor Protection Corporation) insurance. Therefore, I ponder a security breach of my finances about as long as it takes to write a paragraph. The point in connecting your bank account with your checking account is so that you can set up a monthly deposit from your checking into your new investment account, and it is therefore on autopilot.
Step 3 – Decide how much you want to put into this account after each paycheck. Make it hurt.
Here’s the deal, some folks will work through a spending plan to calculate how much they can sock away each month while others, despite their best intentions, won’t. Let’s face it, you’ve come this far, you’ve got a good job and make good money. Your time is stretched thin as it is, and there is little extra time to track all those expenses and monitor your spending plan. While that is always the goal, I understand that some folks just won’t follow this path. Yet, year after year, as time passes, there is no additional money saved.
My suggestion is to start with 10% of your take home pay. If that makes you cringe, cut it by half. Basically, if you bring home a combined amount of $3,500 per pay period (the average in America) then go ahead and set the dollar amount to $350.00 to automatically deposit one day after each paycheck; if you get paid on the 1st and 15th, set it for the 2nd and 16th. If you give yourself too much time in between, you may be tempted to contact Vanguard and to hold off that month. Don’t do it!
Step 4 – Invest for your future. Select the Target Date Funds
This money is post tax, non-retirement capital, which means you can take it out and use it at any time. There are no strange tax laws governing this money mandating you wait until you are 59 ½ or face a penalty for early withdrawal. The only tax consequences, you should know, is that each year any dividends or interest generated by these investments will be taxable; and, when you eventually sell the investment, you’ll pay-long term capital gains tax.
When you’re setting up your monthly contribution amounts, you’ll be prompted to select your investment choices. This is where most folks freak out and hit the pause button. I’m going to make it very simple for you.
Vanguard has a group of mutual funds that are called ‘Target Date Funds.’ Basically, these are funds of funds. This means that all you have to do is select the date, somewhere in the future, when you may use this money. While a new roof may be required next year, I would go into this process with the long term in mind, not using them for the roof that would deplete them. Thus far, you’ve handled emergencies, or big purchases, through your normal cash flow; so, I’m going to encourage you to do the same here. When selecting the target date fund, I would shoot for the fund that aligns with the year you’ll turn 70. For those with some market knowledge, I know what you’re thinking, “That’s too aggressive.” I tend to disagree.
When you’re starting out, the money you invest is small and each subsequent contribution is quite a bit of additional money in % terms. Thus, a big hit in the market early will have you dollar cost averaging with much more of the account than would be the case in the future. For example, if you were to put in $500 and the market had an absolute crash losing 50%, you are down $250, and the very next month you’re adding another $500, at what will certainly be a low point in the market, it lessens the impact so that, as you are starting your investment plan, big swings in stocks just won’t make a huge monetary difference.
Furthermore, I don’t believe that at age 70 one should necessarily be completely out of stocks. I believe that even in retirement a healthy, not crazy, mix of stocks and bonds is prudent. Taking this into consideration, if you look at the current mix of the Vanguard 2020 fund, you’ll see that it is 55% stocks and 45% bonds. https://personal.vanguard.com/us/funds/snapshot?FundId=0682&from=TPV&FundIntExt=INT
However, the Vanguard 2030 fund is 75% stocks and 25% bonds. This is precisely why I would not just use a targeted retirement date but rather 70, or even 80, as my time when having little to no stocks is prudent. https://investor.vanguard.com/mutual-funds/profile/VTHRX
In addition to setting the initial allocation, these target date funds will rebalance over time and the total fee for this investment is a whopping .14%. It’s really tough to beat.
Step 5 – Set it and forget it.
Now that you’ve opened an account, connected it with your checking and begun dollar cost averaging (fancy Wall Street term meaning consistently investing overtime creating an average of purchase prices) into a target date fund, forget about it. Don’t watch it daily, weekly or even monthly. Let it go and revisit it once per year when you’re doing a broad overview of your entire picture. Some years it will do great, others it will stink, but the bottom line is that you have begun paying yourself first and set up a method by which you will no longer go through another year wondering where all the additional capital went.
Step 6 – Increase In Time
I’d say the final kicker here is to increase this amount when and where you can, work hard to never decrease this. If you get a pay raise, then increase the monthly contribution accordingly. The goal is to always be saving an additional 10% or more of your net income; that is, the money that hits your bank account from your employer. If you follow this basic plan, you’ll be in much better shape in the years ahead.
But what about a Roth ?
But Quint, is this the best taxable solution? What about additional savings through a Roth IRA? Yes, it is true there may be better, more tax efficient ways to save non-retirement dollars; but, let’s face it, you haven’t been doing anything so, at least, this is starting you down the right path. Once you get this started, you can revisit and explore other savings options. In most cases, you can move these funds into a Roth, if that ends up being a better solution.
Quint Tatro is Managing Director and Chief Investment Officer of Joule Financial a fee-only advisory and wealth management firm.