All You Need to Know

Greg Spears

I WAS HAVING DINNER in Santa Fe, New Mexico, with a new friend, Joseph. He told me of his frustration with his financial advisor. The two might meet for an hour, but afterward Joseph still didn’t know what to do.

“Explain it to me like I’m five,” he said to me. So I did.

Joseph has a PhD from an Ivy League university, so he doesn’t need a kindergarten story. Yet I understand his frustration. Finance has its own vocabulary that quickly climbs into clouds of abstraction. What are the essential steps we need to take to do well financially?

I’d contend the basics are straightforward—save and invest for a lifetime. I’ll cover the details in a moment. You also need to understand a little human psychology because there are roadblocks in the way. If this were easy, as they say, everyone would do it.

Any good financial plan starts with a clear goal in mind. Nobel laureate Franco Modigliani held that our financial journey’s main objective is to create a smooth level of income over our lifetime. The biggest challenge is to save enough during our working years to avoid a drop in income in old age, which would cause pain and dislocation.

It’s easy to tell people to save—advisors do it all the time. Yet it’s also hard for many Americans to do. Why? Humans have what the great English economist A. C. Pigou described as a “faulty telescopic facility” that makes today’s needs feel urgent and future needs only dimly perceived.

Here’s another way to express it: “The future is an idea we have to conjure in our minds, not something that we perceive with our senses,” writes Bina Venkataraman, a former climate advisor to the Obama administration. “What we want today, by contrast, we can often feel in our guts as a craving.”

This gut desire for instant gratification helps explain why the U.S. personal savings rate was 3.5% in July, much lower than recommended. To overcome the natural temptation to spend our resources today, researchers suggest making saving automatic. This already happens when Social Security taxes are deducted from our paychecks. It doesn’t take willpower—the saving is done for us.

Many employers offer something similar by automatically enrolling their employees in retirement savings programs, such as 401(k)s or 403(b)s. You can drop out at any time, but more than 90% of workers accept these payroll deductions.

The problem with this system is employers often set the savings bar too low, typically starting at 3% of pay and increasing it by one percentage point a year. Nobel laureate Richard Thaler recommends saving at least 10% and says 15% would be better. In that 10% to 15%, you can count any matching contribution your employer makes.

If you’re not saving at least 10%, go to your plan’s website and raise your savings level. If you can’t afford to do so, increase your savings next time you get a pay raise. That way, you can avoid the feeling of loss that comes with seeing your take-home pay drop.

If you don’t have a 401(k), open an IRA. When you do, you’ll encounter a puzzling question: Roth or traditional? Both options reduce your taxes. If you want to cut your taxes this year, make traditional contributions. The earnings you save won’t be taxed today, but the money will be taxed when you take it out. If you withdraw it before age 59½, you’ll also owe a 10% penalty, so think of this money as off-limits until then.

If you want to save on taxes in retirement, choose the Roth. You’d pay income taxes on the money you save today, but not when you withdraw it and its earnings after 59½, assuming you’ve met the five-year rule. The Roth is advantageous for young workers who will make a higher income later on. Still, don’t get hung up on the imponderables. Just make a choice and move on. It’s better that you save money either way than stall out.

Financial conversations really go off the rails when the topic turns to where to invest. Yes, it’s confusing. And, yes, it’s emotionally uncomfortable. Once again, it’s helpful to know why.

There will be down years when you invest, and those losses will cause real emotional pain. I won’t sugarcoat it. It hurts. The bigger risk, however, is missing out on gains and the financial security that comes with them. The stock market has ended the year down in only 27% of the past 94 years, according to Capital Group. The odds are in your favor over the long run, as long as you hang in there.

Here’s more good news: You don’t have to understand Wall Street jargon to invest, any more than I have to understand the internal combustion engine to drive to church on Sunday. Most employee retirement plans have well-diversified investment choices called target-date funds.

These all-in-one investments own a balance of bonds and stocks, and cut risk by reducing their stock percentages as your retirement date nears. Devoted investors may do better by assembling their own portfolio of funds. Still, if you don’t want to read Barron’s on your Saturdays, you could do a lot worse than selecting a target-date fund.

To choose a target-date fund, you only have to decide the year you plan to retire. Someone who is 40 might want to retire in 27 years at age 67. They’d add 27 to 2023 and get their retirement year of 2050. Most 401(k) plans offer a 2050 retirement-date fund—and a 2040 fund, a 2060 fund and so on.

One final point: It’s often a mystery how a financial advisor gets paid. Clear it up by asking if he or she is paid by commission. If the answer is yes, thank the advisor kindly and walk away. If it’s an insurance salesman you’re talking to, say thanks and run away. Insurance products disguised as investments are guaranteed to cost you too much.

There are many outstanding investments available with no commissions. In financial speak, these are called “no-load.” Demand these investments for yourself. Any advisors you work with should also be a “fiduciary,” which is a complicated way of saying they’re required to put your needs ahead of their own. Just ask them if they’re a fiduciary to find out whose interests they serve first, yours or their own.

Let’s review. The essence of anyone’s retirement plan consists of just four steps:

  • Save at least 10% of your income in a retirement plan, though 15% would be better.
  • Choose “Roth” if you want to save taxes in retirement and “traditional” if you want to save on income taxes next April 15.
  • If you aren’t an investment maven, stash your savings in a target-retirement fund with the year you plan on retiring, for example, 2050 or 2060.
  • Make sure you’re not paying any sales commissions on your investments. You want no-load funds only. And ask your financial advisor if he or she is a fiduciary.

I could make this a whole lot more complicated, Joseph, but these are the all-important basics. As Nike says, “Just do it.”

What’s the wisest financial advice you’ve ever been given? Share your thoughts in HumbleDollar’s Voices section.

Greg Spears is HumbleDollar’s deputy editor. Earlier in his career, he worked as a reporter for the Knight Ridder Washington Bureau and Kiplinger’s Personal Finance magazine. After leaving journalism, Greg spent 23 years as a senior editor at Vanguard Group on the 401(k) side, where he implored people to save more for retirement. He currently teaches behavioral economics at St. Joseph’s University in Philadelphia as an adjunct professor. The subject helps shed light on why so many Americans save less than they might. Greg is also a Certified Financial Planner certificate holder. Check out his earlier articles.

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