Americans aren’t saving nearly enough — and it’s only gotten worse since the financial crisis in 2008. Eight years later, most Americans are still reeling from the experience. In 2015, household debt climbed by $212 billion to $12.07 trillion — the largest increase since 2010. According to research conducted by the Economic Policy Institute, a DC-based think tank, nearly half of all American households have no retirement savings at all. These facts set the stage for a dismal financial future, but it doesn’t have to be that way.
Most retirement savings today are defined-contribution plans, typically 401(k) plans and individual retirement accounts (IRAs) — a sea change from just 30 years ago when most Americans were covered by defined-benefit plans, like a pension. In defined-contribution plans, savers put aside a certain amount of money from each paycheck to save for retirement. Your retirement income under these plans depends on how much you’ve saved and on what returns you’ve realized on your investments.
The benefit of these plans over the earlier defined-benefit plans is that they give individuals greater freedom over their retirement savings, but that freedom comes with greater responsibility – and that responsibility can be scary. How do you get on track?
Luckily, the key principles for successful retirement savings are surprisingly simple — and the advice holds up for just about everyone, from those who don’t know the difference between an IRA and an RIA to a finance professor like myself.
Start with this: For every $100 that you have set aside for retirement, invest some fraction; say 80 percent, in a broad index of all stocks (a total stock market index, or an S&P 500 index fund will do the job nicely). For new investors, this can seem more difficult than it should be. There are thousands of index funds to choose from, so which should you pick? Easy: pick a mutual fund or an exchange-traded fund (ETF) with the lowest fees. How low? An expense ratio of 0.1 percent or less is perfect. Fees higher than 0.3 percent are too high. Remember each fund is selling you access to exactly the same product(the whole US stock market) so all that matters is picking a fund with the lowest cost.
Next, take the remaining 20 percent and put it in ultra-safe assets like CDs, US government bonds, or a government fixed-income fund — bonds that have a fixed specified payment in the future. Bonds have lower expected returns, but their value is less volatile than stocks so they provide better security. Again, find a fund with lowest available fees.
Right now you may be asking, “Where did this notion of an 80–20 split come from?” The answer is it comes from balancing the higher expected return of stocks with the extra safety of bonds.
History suggests that, on average, stocks return five percent more than bonds each year. But stocks are also more volatile. One way to think about this risk is that, on average, once every three years stocks will lose value relative to bonds — and every once in a while they lose a lot. From 1929–32, stock market investors lost 84 percent of their savings. In the Great Recession of 2007–09 that drop was about 55 percent.
Big dips like this can be frightening. But, we know that the higher five percent expected return on the total stock market is a very good deal. So, putting 80 percent of your money in stocks early on in your working life is probably the best idea for most people. Most finance professors and economists agree that this fraction should be gradually lowered as you get closer to retirement, because if your stock investments lose money (think about losing 37 percent of your savings as investors in the S&P 500 did in 2008!) you’ll have less time to adjust by working longer and saving a little more to make up the difference.
Now, if all of this sounds complicated, I understand. But there is one piece of good news: most investment management companies provide “lifecycle funds” or “target date funds” that select an appropriate mix of stocks and bonds for you based on your target retirement date, and recalibrate that mix over time as you age. The only drawback to these funds is that the fees they charge are often higher — so you need to be very careful to make sure you find a low fee option if you select this route. You should also look carefully at the mix of stocks and bonds they choose to make sure you are comfortable with the particular allocation.
You may be thinking — isn’t it better to try to pick good stocks myself to save some money? The answer is simply: no! You’d be competing with tens of thousands of people who pick stocks for a living.
The evidence suggests that personal trading regularly ends up costing individual investors a lot of money in fees while delivering little benefit. By picking a small handful of stocks, you give up the diversification benefits of a broad index, increasing the risk to your savings, and receive no extra returns to compensate.
What about paying an “active” fund manager to invest for you? That sounds like a good idea. That’s what all those charts, statistics, and terminology are designed to convince you of. But, at the end of the day, the overwhelming evidence is that most managers don’t do better than picking stocks randomly, and any benefit they do generate is nullified by the fees they charge for the service.
Should you invest less in stocks when the market falls? No — if anything data suggests you might be slightly better off doing the reverse. If you read that unemployment is falling, should you buy more stocks? No. The stocks market reacts to all that information within seconds. Trading based on information like this is like running for a train that has already left the station. You’ll simply never catch it.
So, now you know what a finance professor’s retirement portfolio looks like. There are lots of equations and data to back up the answers here, but, thankfully, you can rest easy knowing that you have one less thing to worry about.
Andrew Hertzberg is an assistant professor in the Finance & Economics Division at Columbia Business School.
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