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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:
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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I would also add that one should run away from advisors who charge AUM fees. A fee-only advisor works perfectly fine for most of us – whether you are starting out in life or have a large portfolio.
A quibble: Advisors who charge AUM fees are considered fee-only. I assume your recommendation is to hire an advisor who charges by the hour or charges a fixed retainer.
Good article. One thing I would highlight to folks is that when young people come to you for advice about investing, first gauge their comfort level with investing in risky assets like stocks. Loss aversion is a powerful emotion and you don’t want them to walk away in a market downturn because they weren’t prepared. Focusing on saving is more important at this stage of a young person’s life than asset allocation – a CD, short term government bond fund, etc. is perfectly fine. Ease them in.
Great comment and something I was thinking of recently. I’ve given young people advice that they can be very heavy stocks, which of course market history supports, but you never know what one’s psychology supports. Nor do they really until they’re tested.
I agree with the suggestions you make, but we should acknowledge that you have to be able to save 10-15% of your income before a Roth IRA and target date fund become relevant. Unfortunately, too many Americans do not earn enough to be able to save much or any of their income.
Generally agree with the article. That said, as someone who has chosen to go with an advisor in retirement (I was DIY while working), I have the following comments: 1- The lead-in to the piece starts with this:” 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.” Sorry but this is a crappy advisor-Fire that advisor and get a new one. Yes DIY can be an option but’s not the only one. There are good advisors out there who do a lot more than hand holding (as noted by another commenter). 2-The suggestion on an advisor is avoid to those who make commissions. I agree, and not only because this is typically not in the client’s best interest and costs money but typically because these so-called advisors are frequently not advisors at all in practice. 3-I would personally add many AUM “advisors” to the category of advisors to avoid because they get paid based on assets rather than on professional services delivered. And some focus too much on stock picking and investments and not enough on holistic advice. I prefer the independent flat fee only model. 4-Finally, I disagree with the advice to look for fiduciary. Its a nice idea but essentially these days fiduciary is a marketing tool. And a deeper look sometimes reveals while they say they are fiduciary, their investment advice surprisingly benefits them also.
EXCELLENT!
A while after my daughter got divorced I reviewed the finances that her ex husband had set up. There were multiple funds with a commission-based person with very high fees. I explained to her that saving for retirement can actually be quite simple, and she could do it herself. I explained it to her much as you did Greg. We set up a Vanguard target date fund for her, and off she went.
One possible tweak that I would add. If the person you are advising knows they have conservative versus an aggressive investment philosophy they could pick a target date fund either five years earlier or later than the one for their age.
This is great. I sent a link for this article to my sons. I hope they read it.
Good artcle! One thing I would note is that your advice seems to assume that there is no need to compare target date funds.
If you’re investing through a 401(k) or 403(b), you’ll likely be stuck with a single fund company’s offering. But if you’re investing on your own, I’d favor the index-based target funds offered by Fidelity, Schwab and Vanguard.
Never thought well of using an advisor, but if you found one that is fee based, moderate fees, for many it will be well worth it. They will control your behavior which is a failing of many of us. Read Simple wealth by Nick Murray and digest his messages. Selection of funds is the easy part. Manage one’s emotions when you see a 50% decline is not easy
Some topics cannot be simplified, and I think that this may be one of them.
For example “Choose “Roth” if you want to save taxes in retirement and “traditional” if you want to save on income taxes next April 15,” is entirely too simplistic to allow a saver to make a good decision.
Agree with this comment. If you have a high income, deferring may be preferable. Particularly if income is projected lower in retirement where there also may be an opportunity for Roth conversions in early retirement.
You’re probably right, but believe the author recognizes that Roth vs Traditional is much less important than saving methodically and investing responsibly. “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.”
In that case, how would you frame the issue for a friend who’s trying to choose between a Roth and a traditional retirement account, and who knows little about managing money and has scant interest in finance? You have 30 seconds to ensure he or she makes a good decision. Go.
I will try that challenge: “If your current tax bracket is over 22% go Traditional”.. thoughts?
Jamie, I don’t disagree, but this would of course assume that current (historically low) tax rates will not increase in the future. Obviously no one knows the answer for sure, but I have heard compelling reasons why they might. (The current levels of government borrowing being unsustainable at current tax rates, for instance.)
Again, it requires a more in-depth analysis and discussion, but simply telling someone that Traditional avoids taxes now while Roth avoids taxes in the future likely is the simplest way to convey the relevant information.
Both, as you really can’t know for sure which will end up having been the better decision, and it’s not as if either is wrong.
Not what I did, but that would be my advice for a friend like the one described.
Great points Greg. Most people don’t need an advisor. Stay with the basics and stay the course. The problem is there are too many variables, too many choices, too many rules applied differently. I’m about to send Jonathan an article along those lines.
Nice article Greg.
I was sure someone would have beaten me to this comment, and am surprised you didn’t include it yourself.
If you’re unsure whether you want a Traditional or Roth IRA, open and contribute regularly to both.
Yes, it’s best to max out IRA contributions and any 401(k) employer match before investing in a taxable account with its associated tax drag.
Greg,
Excellent post!
Your friend may want to use his favorite search engine to look for the phrase:
“financial advice on an index card”
It explains things pretty clearly.
I took my shot at the index card back in 2016:
https://humbledollar.com/2016/01/five-keys-to-financial-wellness/
You hit the bull’s eye with that shot. Thanks!
Great article Greg. To “paraphrase”:
1) Save at least 10% of your income. Without this step, none of the other steps matter.
2) Choose a Roth account if you want tax-free retirement income AND the potential for tax-free Social Security; or choose a Traditional account if you wish to pay taxes on your retirement income AND you’d rather have taxable Social Security. If the whole idea of retirement accounts too confusing, just open a simple brokerage account and refer to step #1, then proceed to steps #3 and #4.
3) Target-date funds are a fine choice, especially if you don’t want to bother with learning a few basics about markets and investing (and sometimes, even if you do).
4) Paying for investment advice is nearly always a bad investment. If you need help getting your financial life in order, don’t hesitate to employ a financial planner, but make sure they are paid in such a way as to benefit of both of you.
–There, no more excuses! Make it happen.
I’d recommend an addendum to your fourth bullet, which is: if you do use an advisor, try to find one who is “fee-only”, not merely a fiduciary.
Ah, the KISS plan. Financial advisers try to make it complicated for a reason, to make us think we need them. I have seen investment portfolios managed by financial advisers that friends and relatives asked me to review that were overly complex with expensive funds in them. This has an intimidating affect, and makes people feel they need a financial advisor to manage them.
As your nice article states, we do not need them. In fact, a simple low cost plan without their fees will do much better without them.
Greg…One of your best. Simple, straightforward, plain common sense. I never had to worry about “faulty telescopic facility.” I had a very clear-eyed view of whaat the future would be like without savings. Being poor gives one that insight and, hopefully, the motivation and prudence to follow through to maintain self-sufficiency.
1) Have a plan
2) diversify
3) be patient