Chances are, living the life you want after you retire will depend on your investment income.
In many ways, investing for retirement is just like investing for any other reason. You use your principal, or the money you have, to try to earn more money, which you can use to pay your bills, buy something you want, or make a new investment. But when you're investing for long-term financial security, there's no fixed moment when you need the money. Instead, it's a continuous process.
That means you always have to think about doing three things:
Making your investment grow
Preserving your principal
FIRST THINGS FIRST
If you're putting money into an employer-sponsored savings plan, an IRA, a SEP, or a Keogh, you're already investing for retirement in a way that provides the extra advantage of tax deferral on earnings and sometimes on your contributions. Those contributions may be most, or even all, of what you feel you can put away. Yet, being able to afford the kind of retirement you want will depend - in most cases - on the personal investments you make in addition to the money you put in tax-deferred plans. If you don't start until retirement is within sight, it can be tough to invest enough to produce the income you'll need.
THE GROWTH STAGE
Growth is the first order of business, and investments may grow in many ways:
You can beef up your principal on a regular basis by contributing a percentage of your income to your investment pool. Putting $6,000 into an IRA is an example, as is adding an additional $1,000 per year if you're 50 or older.
You can reinvest your investment earnings rather than spend them, either by using a tax-deferred plan or by putting all your taxable interest and dividend payments into an investment account.
You can invest your money in places where it has the most potential to grow in value over the long term, typically in equity products like stock and stock separate accounts. But you have to be prepared for the fact that you could lose rather than make money, especially in the short term.
You can diversify, or put your money into a variety of investments, to take advantage of ups and downs in the stock and bond markets and the interest rate, and protect yourself against major losses in one area of the investment markets.
COMING UP SHORT Most experts agree that you're likely to need about 80% of your preretirement income after you retire if you want to maintain a similar style of living. Social Security benefits and, in some cases, an employer-sponsored pension, will supply some of what you need.
For example, if you're earning $75,000 when you retire, your financial picture might look like this:
$75,000 x .80 Preretirement income
= $60,000 Post-retirement need
- $15,600 Social Security benefits
- $22,500 Pension benefits
= $21,900 FIRST YEAR INCOME SHORTFALL
MAKING UP THE DIFFERENCE You might go on working part-time, if jobs are available, though that may not be your idea of retirement. The other option - short of winning the lottery - is a regular income from the investments you've built up over the years. The more carefully you've planned those investments, the more likely it is that you can count on them to produce the earnings you'll need. Here are three hypothetical examples of ways you might provide that income in the first year of your retirement:*
$8,250 Interest from $150,000 in Treasury bonds paying 5.5%
+ $4,500 Liquidating 5% of a $90,000 stock portfolio
+ $13,750 Withdrawing 5% of assets in $275,000 Keogh plan
= $22,450 INCOME FROM INVESTING
* These examples are hypothetical and do not reflect the return on any individual investment or combination of investments. Taxes due on investment earnings are not included in these calculations.
THE INCOME STAGE
Income-producing investments are especially important when you need money to live on, typically after you retire. For example, the interest on a bond, the dividends from a stock, or regular income from a fixed or variable annuity help cover day-to-day expenses. Since those payments are made regularly - usually semi-annually for bonds, quarterly for stocks, and monthly for annuities - you can plan on them. You can also time certain investments, like certificates of deposit (CDs) or certain bonds, which mature on a specific schedule, to replenish your cash reserve or meet anticipated expenses.
Income from your investments can also produce a regular source of new investment money. Or, you can plan to spend a certain amount and reinvest the rest.
THE PRESERVATION STAGE
If you're living on the income your investments provide, you've got a vested interest in making sure they don't shrink in value or, worse yet, disappear entirely. Curiously, the best preservation technique is to concentrate on growth - maybe slower, safer growth than you were looking for when you first began to build your nest egg, but some growth nonetheless. Money that's not providing a return greater than the rate of inflation shrinks in value. That's one of the biggest threats to your long-term financial security.
WHAT YOU CAN'T KNOW CAN HURT YOU You can't actually know how much you'll need when you retire, or what the state of the economy will be then. You can get a sense if you can project your salary increases, the rate of inflation, and how much you'll be paying in local taxes 10, 20, or 30 years in the future. There's a certain element of unpredictability in any projection, even a computer-generated one. The only thing you can tell for certain is that if you don't invest, you won't have what you need.