Principles of Saving for Retirement

Occasionally, some deep thinkers come along with advice so excellent and points of reference so basic that I feel compelled to pass them on.

Naturally, I wouldn't pass them on if I didn't also agree with them. I think they form a solid basis for your progress on getting that house next to the 16th green for your retirement (if that's what you want).

Miles to Go

The first set of principles come from my old pal and colleague, financial planning whiz Raymond J. Lucia (or Ray Lucia, as I call him). He's written a fine new book called "Ready...Set...Retire!: Financial Strategies for the Rest of Your Life" in which he lays out the six most fundamental considerations for retiring.

Before he even gets to those, though, he insists that you consider how long you're likely to live. Of course, none of us knows the date we'll die, but you can assume that if you make it to 65, you have a darned good shot of making it to 83. And if you're a couple who makes it to 65, there's close to a 40 percent chance you'll make it to 90.

The web site for Northwestern Mutual, a large life insurance company, can help you estimate your longevity. But the main point to bear in mind is that you're probably going to live about 20 years after you retire. That's a long, long time if you don't have enough money saved up.

The Six Principles

With that in mind, Ray presents the bedrock principles that will influence how you live financially after you retire. Specifically, they are:

1. How much you save.

Simply put, if you're a typical American (who happens to save close to zero right now), you have to save more. When you're young, 10 percent of your income will get you there. If you don't start saving until middle age, aim closer to 15 or 20 percent. If you don't start until later than middle age, save every penny you can even if your only in college.

2. How long you give your savings to compound.

The great Milton Friedman famously said that the greatest invention of man was compound interest. Maybe he was joking, maybe not.

In any event, compound interest is a great gift to young people. If you start early, tiny amounts grow to immense amounts, and pretty soon you're all set for retirement. My pal, the genius investment advisor Phil DeMuth, says that if you're old enough to start thinking about sex, you're old enough to start saving for retirement.

A thousand dollars socked away when you're 20 and growing at 10 percent per year will be almost $73,000 when you're 65. The same sum saved when you're 50 will grow to $4,200 at age 65. That's a stunning truth that should compel any young person to start saving early -- and the rest of us to start right now.

As for timing your retirement, Ray advises that if you can push it back by even five years you'll allow your money to grow and have fewer years to need it.

3. How you allocate your assets.

Typically, for those who start early, stocks are the answer. Over long periods, a diversified basket of common stocks wildly outperforms bonds, cash, and real estate. The differences are breathtaking.

But, as we've seen lately, there's also a lot of volatility in stocks. As you age, you'll want more of your money in bonds and money market accounts. These have lower returns than stocks, but they also have far lower volatility.

common stock index such as the Vanguard Total Stock Market Index (VTSMX and half in the Vanguard Total Bond Market Index (VBMFX).

To me, that's a bit conservative if you're young like in college. I would have more in stocks and also a good chunk in international markets. (Phil has written a fine book about supercharging your portfolio that will be out in a few months. It's far beyond his basic portfolio in sophistication and returns, so watch for it.)

Ray has a portfolio that he uses in his "Buckets of Money" strategy that uses stocks, bonds, variable annuities bought with a sharp eye on fees, and real estate, and his returns have been excellent.

4. How much your investment returns annually.

Now, this is largely unknown from year to year. But over long periods, stocks return close to 6.5 percent after inflation, and about 10 percent before inflation.

The supernova-genius of investing, the investor's absolutely best pal ever, John Bogle, who founded index investing through Vanguard Funds, says -- and his evidence is powerful indeed -- that you'll do best as a stock investor with index funds that cover the largest possible universe of stocks in the free world. These tend to be very low-cost in terms of fees and loads (sales charges), and beat almost all actively managed funds in terms of return over long periods.

I heartily concur. I would add that it's also helpful to juice up your portfolio with real estate, and to lean toward high-dividend and real estate funds.

5. How low you keep your fees and costs.

This principle is largely about using index funds and no-load mutual funds, which makes perfect sense.

6. How closely you keep an eye on taxes.

Finally, Ray advises maxing out your tax-protected accounts like IRAs and 401(k)s; keeping high-dividend stocks in accounts that are tax-deferred; and, when retiring, carefully considering what bracket you'll be in and drawing out your funds to remain in the lowest possible one.

Remember the Basics

These are basic principles to be sure, but they're vital. The three most important to remember are: 1) Start saving for retirement when you're young like in college; 2) Save as much as you can; and 3) Maximize your returns by using index funds with low costs and high diversification. (Diversification and time are probably the investor's best friends.)

It may sound simple, but it isn't easy. If you're diligent, though, you'll be well on your way to that house on the fairway.

Have a great day and God bless!