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Saving for Retirement

6 Steps to Building More Wealth

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A decade into retirement, Eileen Kemp is proof that even people with modest means can build sufficient wealth to sustain a satisfying lifestyle. A former elementary school librarian, Kemp started educating herself about investing when she was in her thirties and just beginning to contribute to workplace retirement accounts. Now, at age 70, she’s living comfortably in a home she has paid off, taking annual vacations to Europe and making regular gifts to charity. “I’ve made some mistakes, but I’ve learned things along the way,” says Kemp. “I’m a relatively frugal person, and I have more money coming in than I need.”

See Also: Wealth-Building Secrets of the Millionaire Next Door

At a time when Americans are shouldering increased responsibility for their long-term economic security, Kemp’s story offers encouragement. To be sure, it’s easy to be overwhelmed by the cacophony of competing financial demands, particularly when you’re starting out. And the amount of money that professionals say you’ll need to finance everything from college to retirement can appear daunting. But building wealth over a lifetime is both possible and rewarding. Like constructing your dream house, it takes time, a well-crafted plan and, sometimes, a little help from the pros.

1. Draw up a blueprint

The first step in any major construction job is to create a wish list. When designing your house, an architect is likely to ask for photographs of things you want and like—from crown molding to refrigerators—so he or she can produce a drawing of how the finished project should look and allow you to get an estimate of the cost. It’s wise to be equally specific with your financial wish list.

If you’re like most people, your list will include multiple items—such as buying a house and a car, paying your kids’ college costs, and footing the bill for your retirement. But there’s a vast difference between financing a Toyota instead of a Tesla, or paying for college at a state school instead of an Ivy League university. And a “comfortable” retirement can cost anything from $1,000 to $100,000 a month, depending on whether your typical vacation involves playing Skee-Ball at the arcade or taking ski trips to the Alps. The more specific you make your list, the more accurate your plans will be. So write down your wants, their estimated costs and when you hope to achieve each piece of your plan. When you’re done, the wish list might look something like this:

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  • Accumulate $20,000 (six months’ worth of living expenses) within one year for an emergency fund.
  • Save $50,000 within five years for a down payment on a $250,000 home.
  • Build a kitty of $100,000 (in today’s dollars) to help pay for college in 16 to 20 years for two kids, now toddlers.
  • Save enough in 30 years to generate a monthly stream of income of $5,500 (again, in today’s dollars) for the remainder of your life.

2. Create a budget

Now it’s time to pull out a calculator to see if you can afford the project. This involves figuring out just how much you need to set aside every month for each goal.

Determining the monthly amount required to address a short-term goal is easy. Just divide the total by the number of months you have left to save. So, for example, if you need $5,000 in one year, you would set aside $417 per month.

To estimate the monthly cost of financing goals that are several years away, you’ll want to factor in the impact of investment returns. So you’re best served by a Web-based tool, such as Bankrate.com’s savings goal calculator. Kiplinger’s Retirement Savings Calculator can help answer the more complex question of how much you need to set aside each month for retirement when you’re likely to have part of the bill financed by Social Security and possibly by an employer-sponsored pension plan.

When done, you should have a list with a column that shows how much you need to save monthly for each goal. Adding up the numbers will give you the total amount you should be setting aside each month to attain all of your goals in the time you’ve allotted. If the total is more than you can afford, you have two choices: You can address one or two goals now and the rest later, or you can modify your aspirations.

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For instance, a 32-year-old couple who have nothing saved but want to fund all four of the goals described above would likely feel they face an insurmountable task. Funding all four accounts at the desired pace would cost them roughly $3,700 a month—$1,667 for the emergency fund, $700 for the home, $300 for the college account and about $1,000 for their retirement accounts. (All the calculations assume an 8% annualized return and average inflation of 3% per year. The retirement calculation assumes the couple have no current savings, get matching retirement-plan contributions from their employers and will get $1,850 a month from Social Security.)

A more viable plan might be to cut the size of the emergency fund to, say, $10,000, or to stretch the amount of time for amassing the savings. The couple could also postpone saving for a house until they have built up the emergency fund. But they would be foolish to delay saving for their longer-term goals, especially if it means forgoing thousands of dollars in matching funds from their employers. As an alternative, they could opt to set aside less today, with the understanding that they’ll boost their contributions for long-term goals once they have achieved their nearer-term goals.

3. Select the right materials

The benefit of distributing your savings among a number of goal-related pieces is that it helps with what many find to be investing’s most vexing challenge: how to divvy up your assets among various types of investments, such as stocks, bonds, cash and real estate. Experts disagree on the perfect allocations. But different types of assets each have unique qualities that make them appropriate for specific goals. In the absence of an agreed-upon ideal, simply dividing your assets according to your goals and time frames can work nicely.

For instance, although cash investments, such as Treasury bills, money market funds and short-term certificates of deposit, pay practically nothing nowadays, they keep your principal safe. And that is precisely what you want for an emergency fund or a goal that’s coming up in just a year or two.

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Income-oriented investments, such as government and corporate bonds, generally pay fixed rates of interest and promise to return your principal on specified maturity dates. That makes them ideal for midrange goals that need a predictable source of funding.

Returns from stocks, by contrast, vary greatly over short stretches. But over many years, stocks handily beat the rate of inflation and the return from other investments. That makes stocks great for long-term goals.

Commodities and real estate tend to perform well when other investments are struggling and especially when inflation heats up. Although consumer prices have been tame for most of the past three decades, you never know when inflation will reappear. So it makes sense to put 10% of your long-term assets into commodity funds and real estate investment trusts, says Tony Davidow, an asset allocation strategist at Charles Schwab & Co.

Our hypothetical couple could put their emergency savings in cash, their down-payment savings into a mixture of corporate and government bonds, and their retirement and college accounts in a mixture of stocks, REITs and commodities. However, as long-term goals draw near, they will want to shift some of those assets into bonds and cash. Thus, although the college accounts will start out primarily invested in stocks, the family should start shifting some of the money into fixed-income investments when the kids enroll in junior high. When the oldest child is ready to enroll in college, about one-fourth of his or her college savings should be in short-term CDs and bank deposits. Most of the rest should be in income-oriented investments, such as medium-term bonds that mature as tuition bills come due.

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This “bucket” approach not only provides a simple formula for divvying up assets, it also offers psychological benefits. “When you see that your near-term needs are being taken care of with investments that are not going to swing in value, you can take more risk in the accounts designed to address long-term goals,” says Charles Rotblut, a vice-president at the American Association of Individual Investors, a nonprofit dedicated to investor education.

4. Sweat the details

Spreading your assets among stocks, bonds and cash is just the first step to building a solid investment portfolio. You also need to diversify within those asset classes.

The stock portion of your portfolio should include shares of big companies, small companies, domestic outfits and foreign firms. Some of the companies you invest in should be rapid growers, and others should be value plays—not necessarily fast growers but companies with stocks that are cheap in relation to earnings, sales and other key business measures. Dividend-paying stocks should also play a role in your portfolio.

Meanwhile, the bond portion of your holdings should be divided among bonds with varying maturity dates and issuers, such as corporations and government agencies. You can boost your yield by buying low-rated, high-yield corporate debt, known as junk bonds. But realize that if you reach too far for yield, your bond portfolio will probably be more volatile, Davidow says. That’s because junk-bond prices often react to economic news, much as stock prices do. You can also boost yield by buying long-term, high-quality bonds. But bond prices typically move in the opposite direction of interest rates, and long-term bonds lose more than short-term bonds when rates rise. For steadier results in your bond portfolio, it’s best to stick with investment-grade bonds that mature in less than 10 years.

The broader your investment mix, the less likely that one economic upset will topple the plan. One way to diversify is to own both low-cost index funds—which are designed simply to track a market barometer, such as Standard & Poor’s 500-stock index—and actively managed funds.

Why? Index funds provide an inexpensive way to produce returns nearly equal to those of the market they track. You can choose from index funds that track large-company stocks, small-company stocks, foreign stocks, all sorts of bonds and a wide variety of other asset categories. And index funds are available as both mutual funds and exchange-traded funds.

But sprinkling in a few carefully selected actively managed funds gives you an even better mix, Davidow says. A good fund manager can find stocks that aren’t included in indexes and can concentrate assets where the opportunities are best.

Ideally, a well-managed actively run fund will improve your portfolio’s returns and lower risk. That’s an exacting standard that not many managers can meet. A good place to start your search is the Kiplinger 25, the list of our favorite no-load mutual funds. Considering a specific fund and want to see how it measures up? Go to www.morningstar.com or Kiplinger's Fund Finder tool look at the fund’s performance over both long and short periods.

Retired librarian Kemp doesn’t expect her actively managed funds to beat their benchmarks every year. But she checks their holdings and performance every six months to make sure both the funds and her portfolio are on track. If the holdings within a fund have changed dramatically or a fund is drastically lagging its index for a long stretch, she’ll make adjustments. But mostly, she says, she’s a patient buy-and-hold investor.

5. Control your costs

Investing involves a whole range of costs, among them trading commissions, fund expenses and income taxes. If you’re not keeping a tight rein on expenses, thousands of dollars may slip through your fingers.

If you buy individual stocks, you can save a fortune by using a good discount broker. The typical discount broker charges just $7 per trade, while a full-service firm may charge hundreds of dollars. If you trade often, the difference could add up to thousands of dollars per year.

Fund investors also need to be wary of fees. Diversified U.S. stock funds charge an average of 1.2% per year for management, printing and other costs. But index funds, which don’t hire high-priced managers to pick securities, charge as little as 0.05% per year—that’s a mere $5 per year for every $10,000 invested. Assuming equal performance before the impact of fees, you’ll end up with far more money over the long haul if you invest in a super-low-cost index fund. If you prefer actively managed funds, choose ones that charge well-below-average fees, such as Kiplinger 25 members Dodge & Cox Stock and Vanguard Selected Value. Or, as Davidow suggests, mix some index mutual funds or exchange-traded funds with a few carefully selected actively managed funds.

If you have taxable accounts, the government can also take a big bite out of each trade. If you hold investments for more than a year, you pay preferential capital gains rates to the IRS, usually amounting to no more than 15%. But your state is likely to assess taxes on the gain, too. Add those levies together and you’re likely to lose one-fifth or more of your profit. Savvy investors trade sparingly and attempt to offset capital losses with gains. And if you’re in a high tax bracket, consider investing in tax-free municipal bonds or bond funds for income. Although muni bonds typically pay less than taxable bonds of similar maturity and quality, you may be better off after taxes with lower-yielding munis.

6. Do regular maintenance

Both your portfolio and your life contain a lot of moving parts that need to act in concert to ensure that your money is available to fund the goals you hold dear. So your portfolio needs regular upkeep.

Major life events, such as a job change or the birth of a child, should prompt a portfolio review and possible revisions. As you close in on long-term goals, such as retirement or that first college-tuition bill, shift money into less-volatile investments so you don’t have to worry about a market crash wrecking your plans.

Even in the absence of life-changing events, you should review your portfolio at least once a year. That’s because your investments will move up and down at different times and at different rates. If your stocks soar while your bonds slump, for example, you could find your portfolio too heavily concentrated in stocks. At that point—the end of the calendar year is a good time—lighten up a bit on the asset class that has performed well and invest the proceeds in the lagging category. This technique, known as rebalancing, is a simple way to follow age-old market wisdom: “Buy low, sell high.”

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