THE BASICS OF MONEY
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How do you come up with the right amount to divert to your 401(k) plan?
Financial planners have traditionally estimated that retirees need 70% to 80% of pre-retirement income to maintain their standard of living, but individual situations vary greatly. Paying off a mortgage before retirement can substantially reduce need for income, while paying for health insurance can radically inflate it.
H. Jon Miller, vice-president of the personal financial-planning division for the Northern Trust Co., offers a shorthand formula for figuring out how big a nest egg you need to finance your retirement. Starting at age 65, figure you can spend 4% of your retirement portfolio each year without running out of money.
Here's the math: Assume you need $75,000 a year and that social security and a company pension will provide $30,000 of it. According to Miller's formula, if you divide your unmet need ($45,000) by 0.04, you need to start retirement with a portfolio worth just over $1.1 million.
Taking the time to figure out how much you will need after your paycheck stops could mean the difference between a comfortable retirement or working a lot longer than you had planned.
The "How much do I need to save?" calculator can help you reach a rough estimate.
Once you go through the process to figure out how much money you will need in retirement, then you can figure out how much of your salary you should be deferring in your 401(k) plan and how you should be investing that money to reach your goal. For example, if you are having a hard time deferring 5% of your income and yet you need to set aside more to reach your goal with your current investments, maybe you should adjust your strategy to be more aggressive.
You can use the Test Your Risk Tolerance worksheet to determine how aggressive you should be, or you could look for other ways to pad your 401(k).
Diversify your investments
Regardless of what's offered inside your plan, your objective is to earn a reasonable return over a long period while limiting risk. Market cycles tend to favor one type of investment at the expense of other investments. But cycles change, and because no one knows when that will happen, it's wise to spread your investments over several categories.
If your 401(k) plan is your only major retirement investment, distribute your money among several mutual funds. But if you have investments outside the company plan, make sure your overall retirement stash reflects a good asset mix, even if it means your 401(k) plan is heavily concentrated in one or two areas.
Two-income couples should adopt a similar strategy. You should look at the two 401(k)s as part of a whole, allocating your contributions to the best funds each of your plans has to offer.
Of course, you have to work within the investment options available to you. Typical plans offer about eight investments, including stock and bond mutual funds; balanced funds, which invest in both; "lifestyle" or asset-allocation funds, which include a mix of investments based on your age and how much risk you are willing to take; and fixed-interest investments, such as money-market accounts. An increasing number of plans now allow participants to "self-direct" their account by buying individual stocks and bonds.
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