Q. I’m in my mid-30s and max out my 401(k) and a Roth IRA every year. I also invest $4,500 a year in mutual funds. What more should I be doing to prepare for retirement? Should I invest in individual companies in addition to funds? — Brian B., Jacksonville, Fla.
A. Sounds like you’re already taking the most important steps to get on the path to a secure retirement. You’re saving on a regular basis, maximizing tax-advantaged options — you’re even going above and beyond by investing a substantial sum in a taxable account each year.
Assuming all that saving amounts to a reasonable percentage of your annual income — say, 15% or so — I don’t think you need to make any radical changes.
That said, you may be able to enhance your retirement prospects by improving your retirement-planning strategy a bit. The key, though, is concentrating your efforts in areas that are likely to have the highest payoff.
Here’s what I recommend:
1. When it comes to investing, keep it simple. Unless you believe you have unique insights into the financial prospects for specific companies, I’d pass on investing in individual stocks. Without an edge, you’re not likely to outperform the market averages, and you could end up dragging down your returns.
Similarly, ignore the endless variety of niche funds and ETFs that investment firms constantly churn out. Here, I’m talking about funds and ETFs that home in on particular sectors of the market — oil, gas, platinum, gold, currencies, individual foreign countries, etc. — or that employ risky or arcane investing techniques, a la inverse funds and leveraged ETFs. It’s tough to integrate such investments into your portfolio in a coherent way, and they’re ultimately not worth the extra expense and effort.
Instead, focus on building a straightforward portfolio of broadly diversified stock and bond funds that will give you exposure to all areas of the market. For guidance on how to divvy up your money — between stocks and bonds overall and among particular types of stocks and bonds — just plug the ticker symbol for the Vanguard target-date retirement fund designed for someone your age — in your case, the 2040 or 2045 fund — into Morningstar’s Portfolio X-Ray tool. You don’t have to mimic its allocations precisely, but you probably don’t want to stray too far from them either.
2. Aim for lower costs. Your best shot at boosting your returns without taking on additional risk is to invest as much as possible in low-expense funds. Generally, that means looking for stock funds that have expense ratios below 1% and bond funds with expense ratios less than 0.75%. You can do even better, though, by sticking to low-cost index funds and ETFs like those on the Money 50 list of recommended funds.
Of course, in your 401(k) you’re limited to the menu of investments offered by your plan. But by perusing the fee disclosure the Department of Labor now requires plan sponsors to provide, you should be able to sift through your 401(k)’s investment roster and choose reasonably priced options.
3. Beware investment pitches based on tax benefits. After investing all you can in tax-advantaged 401(k)s and IRAs, you can plow any extra savings into taxable accounts, as you’re already doing to the tune of $4,500 a year.
Just be careful. Many advisers are quick to recommend variable annuities or life insurance investments for taxable accounts because of their potential tax savings. Problem is, these options typically come with high fees, not to mention a mind-numbing level of complexity.
A better solution is to stash any saving you do outside 401(k)s and IRAs in tax-efficient investments like index funds, ETFs and tax-managed funds. You’ll likely pay far lower expenses, which will give you a better shot at a higher after-tax rate of return.
4. Save more as your income rises. There’s a natural tendency for people to ratchet up their lifestyle at a faster rate than their paycheck as it grows. But that can lead to problems come retirement time. The reason: As your income climbs, the percentage of your pre-retirement salary that Social Security will replace starts to shrink.
So the more you earn during your career, the more you’ll have to depend on your personal savings to maintain your standard of living in retirement. To avoid having to scale back your lifestyle during retirement, try to increase the percentage of your income you save as your earnings increase.
5. Monitor your progress. Over the course of a career, any number of setbacks — layoffs, market downturns, etc. — can derail even the best laid retirement plans. That’s why it’s crucial to evaluate how things are going and make adjustments if necessary.
You can do that several ways. One is to periodically assess the balance of your retirement accounts relative to your annual income. The important thing, though, is that one way or another you come away with a realistic sense of whether your current saving and investing plan is working and, if not, make the necessary tweaks to put you back on track.
You already appear to be off to an excellent start in your retirement planning. And if you follow these five tips, your chances of making a smooth transition from the work-a-day world to your post-career life should be just as upbeat.