102: Investing for Retirement

You understand your investor temperament and your time horizon. Now it is time to act. These seven rules will guide every retirement investment decision you make — and the rest of this lesson shows you exactly how to put them to work.

If you have not yet read Learning to Invest, start there. Understanding why you invest — and how your personality shapes the way you respond to market swings — is the foundation everything here is built on.

Essential Retirement Investment Rules

1. Start now! Contribute to your workplace retirement savings plan, if available, or open a Traditional or Roth IRA today.
2. Always get your company match! Invest at least the minimum in a workplace savings plan to receive your company's match. You are leaving free money on the table if you do not.
3. Set up an automatic investment. This can be done from your bank account or directly from your paycheck.
4. Take advantage of dollar-cost averaging. Determine how much you can afford to invest on a bi-weekly or monthly basis and ensure you are reinvesting dividends.
5. Use low (<0.1%) expense ratio, broad-market index funds with no load fees. Do not pay more than necessary to invest your money.
6. Increase your investment amount every year, or with every raise.
7. Maximize your contributions. It takes time, but the goal is to maximize your retirement savings contributions across all savings plans.

It could not be said better than by Warren Buffett, who revealed in his 2013 Berkshire Hathaway Shareholder Letter what he has designated in his will for his wife's trust. I encourage you to read his words in this letter.

My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.

The key is to purchase a broad-market, low-fee, no-load fund. This can be an index fund such as Vanguard's S&P 500 ETF VOO, which tracks the S&P 500 and is the index fund Buffett refers to above. Its expense ratio is 0.03%. Another broad-market fund is the SPDR S&P 500 ETF Trust SPY, which carries an expense ratio of 0.0945%. These track the exact same index, but SPY costs roughly three times more than VOO to hold. That is exactly what Buffett was trying to convey. Over the long term, both will perform essentially the same — and that extra cost is simply not worth it for the average investor.

Even better than VOO is Fidelity's ZERO Large Cap Index Fund FNILX. This fund launched in 2018 and carries a 0.00% expense ratio. The difference here is this is a mutual fund — shares are purchased at the end of the trading day when the market closes, rather than throughout the day like an ETF. This means reduced liquidity: you cannot sell shares at a moment's notice the way you can with a stock or ETF. For a long-term retirement account there is no need for that kind of liquidity, and you cannot beat a zero expense ratio. As of this writing, Fidelity is the only provider offering zero-expense funds.

If you want to match Buffett's 90/10 strategy, but do not want to manage buying treasury bonds yourself, there are ETFs that handle this for you. A few low-cost options from major investment firms are Vanguard's Short-Term Treasury ETF VGSH, Schwab's Short-Term U.S. Treasury ETF SCHO, SPDR Portfolio Short Term Treasury ETF SPTS, and Fidelity's Short-Term Treasury Bond Index Fund FUMBX, which is again a mutual fund. All of these carry a 0.03% expense ratio, which is well worth the convenience of maintaining the right distribution of treasury bonds and not needing to maintain your own bond ladder.

Dollar-Cost Averaging & Compound Interest

Dollar-cost averaging is an investment strategy where you invest a fixed amount of money at regular intervals. This method removes emotion from the investment. It buys fewer shares when prices are high and more shares when prices are low. Over time, when applied consistently on a long-term basis, this averages out all the highs and lows and gives you the average price for the asset you are purchasing. It has been shown to do better than trying to time the market with your purchases. This process is exactly what happens when you invest through a workplace savings plan every paycheck, or auto-drafting funds directly into an IRA account every month — regardless of what the market is doing at that moment.

Compound interest is simply the interest you earn on the interest you have already received, accumulated over time. If you have no money invested, you earn no interest. Interest comes in many forms: for an ETF such as VOO, distributions in the form of dividends are made quarterly, as they are for most stocks and ETFs. For mutual funds and other fund-based investments, distributions may occur only once or twice a year. Another form of return in funds is called a capital gains distribution. This occurs when the fund sells stocks it holds at a profit; those gains must be distributed to shareholders, typically quarterly or at year-end.

Through periodic, steady investments and compound interest, your money continually earns returns. When you reinvest your dividends and distributions, your money grows in two ways: first through future interest earned on that interest, and second through the value of additional shares purchased with your distribution. All earnings are added back into your balance. Over subsequent periods you earn on that larger base, creating a snowball effect that accelerates significantly over time.

Types of Retirement Savings Plans

Depending on where you work, there are many types of retirement plans. The key takeaway is that they all operate the same way: as long as you contribute, your employer will match a portion — typically 4% or 5% of your income.

If your employer offers a retirement savings match, contributing at least enough to receive the full match is the single highest-return investment you can make. A 50% or 100% match is an instant guaranteed return on your contribution — something no stock or fund can promise. Not taking it is leaving free money on the table.

A future post will cover the differences between these accounts and how they can be used together. Below is a list of account types offered by employers. Details can be found on the IRS website.[3]

Common Employer-Based Plans

• 401(k): This is the most common plan for private-sector employees. Available in Traditional (pre-tax contributions) and Roth (after-tax contributions) options.
• 403(b): Similar to a 401(k), but specifically designed for employees of public schools, colleges, and certain non-profit organizations.
• 457(b): Similar to a 401(k), but is an employer-sponsored plan for state and local government workers, as well as certain tax-exempt non-profit employees.
• Pensions (or a Defined Benefit Plan): This is an employer-managed plan that guarantees a specific, fixed payout during retirement based on your salary and tenure. Nearly extinct in the private sector but common for Federal and State employees and the military.
• IRA: This is an Individual Retirement Account and is self-driven, meaning any individual with taxable income can open an IRA. These are available in Traditional (pre-tax contributions) and Roth (after-tax contributions) options.

Self-Employed or Small Business Plans

• SEP IRA: Simplified Employee Pension, allows employers, or self-employed individuals, to make contributions to traditional IRAs set up for employees and themselves.
• SIMPLE IRA: Savings Incentive Match Plan for Employees geared toward small businesses, allowing both employer-matching and employee salary-reduction contributions.
• Solo 401(k): Also known as an Individual 401(k), and is designed for self-employed individuals with no employees other than a spouse.

Other Types of Company-Based Plans

• HSA: Health Savings Accounts are not a retirement account, but they act very similarly to one — providing long-term tax sheltering with some form of company contribution to the plan and the ability to invest this money.
• Student Loan Repayment Assistance: Many companies that are looking to bring in new graduates, or be competitive for talent, will either match your student loan payments or even pay off the debt after a set period of service to the company. This is separate from Public Service Loan Forgiveness (PSLF) which is a Federal loan forgiveness program for certain types of government employment that maintain employment for a set number of years as a public servant.[4] PSLF does not extend to contractor, or support employees, who work for a state or federal government. Please read the qualifying rules as these tend to change frequently.
• Stock Options and Employee Stock Purchase Plans (ESPPs): This is common with start-ups and tech companies. An ESPP allows you to buy company stock at a discounted price, usually 5% to 15% lower than the market value. You contribute to this plan via payroll deductions over an “offering period” and while not “matched,” your boost comes from selling these stocks back at their discounted price.

Final Thought

Do not wait for the perfect time to start your retirement savings. Starting now with a small monthly investment makes a significant difference over the long term. Even if your employer does not offer a retirement plan, open your own IRA through any of the brokerage platforms mentioned in the previous lesson. If you are self-employed, look into options specific to your situation. The goal is to develop the habit of consistently depositing into a long-term retirement account and increasing those amounts as your income grows.

Return to Learning to Invest to revisit investor mindset, or build your financial foundation with Learning to Budget.