« August 2003 | Main | December 2003 »

November 1, 2003

Getting a Late Start on Retirement

Suddenly realize you're getting older and still haven't saved much for retirement? Don't just avoid the entire topic, knowing you won't like the answers. If you're getting a late start on saving, you need to take some drastic steps:
  • Go back to the drawing board. You need to thoroughly analyze your situation, calculating how much you'll need for retirement, what income sources will be available, how much you currently have saved, and how much you need to save annually to reach those goals. Can't save the amount needed? Then change your retirement goals. Postponing retirement for a few years will give you more time to accumulate your savings and delay when withdrawals from savings begin. Or consider working after retirement on at least a part-time basis. Even a modest amount of income after retirement can substantially reduce the amount needed for retirement.

  • Contribute the maximum to your 401(k) plan. Your contributions, up to a maximum of $12,000 in 2003, are deducted from your current-year gross pay. If you are age 50 or older, your plan may allow an additional $2,000 catch-up contribution. Earnings and capital gains on investments grow tax deferred until withdrawn. If your employer matches contributions, contribute at least enough to receive the maximum matching amount.

  • Look into traditional deductible and Roth individual retirement accounts (IRAs). Even if you participate in a company-sponsored retirement plan, you can make contributions to a deductible IRA, provided your adjusted gross income does not exceed certain limits. The income limits for nondeductible Roth contributions are even higher.

  • Use your peak earning years to substantially increase your savings. Typically, your last years of employment are your peak earning years. Instead of increasing your lifestyle as your pay increases, save all pay raises. Consider lowering your standard of living, putting any cost reductions into savings. This can also reduce the cost of your retirement. A lower standard of living now typically means you'll be satisfied with a similar lifestyle after retirement.

  • Buy a smaller home. Consider selling your home and moving to a smaller one, especially if you have significant equity in the home. If you've lived in your home in at least two of the last five years, you may exclude $250,000 of gain if you are a single taxpayer and $500,000 of gain if you are married filing jointly. At a minimum, this strategy will reduce your living expenses, allowing you to save more. If you have significant equity in your home, you may be able to set some of the proceeds aside in savings.

  • Restructure your debt. Check if refinancing your mortgage will reduce your monthly mortgage payment. Find less costly options for consumer debts, including credit cards with high interest rates. Systematically pay your debts down. And the most important point -- avoid incurring new debt. If you can't pay cash for something, don't purchase it.

  • Stay focused on your goals. At this age, it's imperative to maintain your commitment to save.

A Portfolio Review

With market declines, it may be painful to look at your portfolio in depth. But that review is needed at least annually to determine whether you are on track to accomplishing your goals. Consider these steps to help in that process:
  1. Measure the performance of each investment in your portfolio. Many investments and investment managers will provide you with periodic performance information. If you invest in individual stocks and bonds, you may need to calculate those returns yourself. Your total return equals the change in market value plus any dividends, interest, or capital gains, divided by the beginning market value. Total return can be difficult to calculate, especially if you make additional investments or withdrawals during the year. You may need the help of a computer program to calculate your total return precisely.

  2. Compare each component of your portfolio to an appropriate benchmark. A wide variety of market indexes now exists, covering many different segments of the market. You should be able to find ones that track investments similar to each component of your portfolio. Making comparisons to a benchmark should help identify portions of your portfolio that may need changing or that you want to start monitoring more closely.

  3. Calculate your overall rate of return, comparing it to your estimated return. When designing your investment program, you probably assumed a certain rate of return which determined how much you needed to invest to achieve your financial goals. Calculating your actual return will determine if you are on track. With the recent market declines, you are likely to find you have not made that much progress or may have lost ground over the past couple of years. In that case, you need to take a fresh look at your financial goals and your current investments, and then recalculate how much you should be saving on an annual basis to reach your goals.

  4. Review your overall allocation to determine whether changes are needed. This annual review is a good time to compare your actual allocation to your desired allocation. You may find you need to make changes for a variety of reasons. Over time, you will find your allocation shifts due to varying returns on different assets. You may also need to sell certain investments that are not performing well. Your asset allocation is likely to need refinement, since your strategy will change over time.

You should review your portfolio's performance annually to ensure your investment strategy is on track.

Take a Look at Treasury Inflation Protection Securities (TIPS)

Treasury Inflation Protection Securities (TIPS) are bonds issued by the U.S. Treasury that pay a real rate of return above increases in inflation. The designated interest rate is determined at auction, with interest paid on the principal value every six months. The principal value is adjusted for inflation based on the increase in the Consumer Price Index for All Urban Consumers (CPI-U). Thus, although the interest rate does not change, the principal grows every six months so that subsequent interest payments are based on the increased principal amount.

Interest payments are subject to federal income taxes, but not state or local income taxes. Also, any increase in the bond's principal value is subject to federal income taxes in the year the adjustment is made, even though the funds aren't received until the bond matures. However, if you hold TIPS in a tax-advantaged account, such as a 401(k) plan or an individual retirement account, you avoid paying income taxes until the funds are withdrawn.

When inflation levels are low, why should you consider TIPS? One reason is that bonds are often purchased for the long term, and over the long term, it is difficult to predict what the inflation rate will be. Owning TIPS removes inflation risk from your bond investment.

To determine whether TIPS are a better alternative for you than other Treasury securities, compare the yield of TIPS to a regular Treasury security of the same maturity. The difference in yield should be compared to your expectations of inflation. If the yield difference is more than expected inflation, then you might not want to purchase the TIPS. If the yield difference is lower than expected inflation, then you might want to purchase the TIPS.

What if we enter a period of deflation? Then your principal value will decrease so that your interest payments will also decrease over time. However, when the bond matures, you still receive the full principal value.

All About Zero-Coupon Bonds

Zero-coupon bonds do not pay interest during the bond's life. Since most bond investors choose bonds for the periodic interest, this may seem like a contradiction. However, some investors don't need the income, but still desire an investment with a fixed return on their principal. The zero-coupon bond does that.

Zero-coupon bonds are issued with a deep discount from face value. The return results from the bond's price increasing gradually from the discounted value to the face value, which is reached at maturity. The longer a zero-coupon bond has until maturity, the greater its price discount will be.

The bond's interest rate is locked in at purchase, but no interest is paid until maturity. Instead of receiving semiannual interest payments, your principal earns the stated interest rate compounded over the bond's life. When the bond matures, you receive the principal and interest -- the bond's face value.

Since you don't receive any of your investment until maturity, choose a zero-coupon bond with a high credit rating. U.S. Treasury bonds are the safest zeros since they are guaranteed by the U.S. government. However, many corporate and municipal zero-coupon bonds are also offered with high credit ratings.

Like other fixed-income investments, a zero-coupon bond's price moves up when interest rates fall and down when rates rise. However, since zeros lock in a fixed reinvestment rate of interest, they are affected more drastically by interest rate changes. As a general rule, for every 1% movement in interest rates, a zero-coupon bond's market value will adjust by approximately 1% for every year left to maturity. So, if interest rates increase 1% and you're holding a zero-coupon bond that matures in 10 years, your bond's value will decrease by approximately 10%. Due to the large potential fluctuations, it is generally recommended that you buy zeros with the intent of holding them to maturity, when you receive the entire face value.

Zeros have several unique features that may be attractive to investors:

  • Your principal earns the stated interest rate compounded over the entire time the bonds are outstanding. With other types of bonds, you receive periodic interest payments which need to be reinvested. Not only do you have to find a place to reinvest, but you invest every six months at varying rates of return.

  • You can purchase zero-coupon bonds to mature at a specific time for the amount needed, providing a convenient way to fund known future expenses.

  • For a small initial investment, you can purchase a bond that will pay a much larger amount at a later date.

One important factor to consider with zero-coupon bonds is taxation. Even though you do not receive any interest income until your bond matures, you are taxed on the yearly growth in the zero's value (called accretion).

There are ways to avoid the tax. You can invest in zero-coupon bonds within a tax-deferred account, such as a 401(k) Plan or an Individual Retirement Account (IRA). That way, you defer taxes on the income until the money is withdrawn. Or you can purchase zero-coupon municipal bonds, whose accretion is not subject to federal income taxes. These bonds may have call provisions, however, so carefully research your options before purchase.

Keep These Bond Tips in Mind

Interest in bonds has grown due to declines in the stock market, but the current low interest rate environment means investors need to carefully devise investment strategies for bonds. Consider the following tips if bonds are part of your investment portfolio:
  • Follow interest rate trends. At a minimum, follow the prime rate, Treasury bill rates, and Treasury bond rates. Understand the significance of the yield curve and follow its pattern over time. A knowledge of current interest rate levels can help you evaluate the appropriateness of a specific bond's interest rate.

  • Carefully choose maturity dates for bonds. The date you need your principal is an important factor, but other factors should also be considered. For instance, bonds with longer maturities are more significantly impacted by interest rate changes. So in volatile environments, you might want to shorten maturities. Reviewing the yield curve might suggest that a slightly longer or shorter maturity is more appropriate. Rather than investing in one maturity, you may want to stagger or ladder the maturity dates, purchasing short-, intermediate-, and long-term bonds.

  • Understand specific bond risks. The most significant risk is interest rate risk. When interest rates rise, bond values fall, while values rise when interest rates decline. Other risks include default risk, or the possibility the issuer will default on the payment of interest and/or principal; call risk, or the possibility the issuer will redeem the bond before maturity; and inflation risk, or the possibility high inflation will outpace the bond's return.

  • Diversify your bond holdings among different bond types. You should consider government, corporate, and municipal bonds as well as different industries, credit ratings, and maturities. There are a wide variety of bonds, so make sure to select ones you are comfortable owning.

  • Understand the bond's terms before purchase. Make sure to review the credit quality, coupon rate, call provisions, and other significant factors.

  • Compare interest rates for specific bonds before investing. Interest rates can vary significantly between different types of bonds and between bonds with different maturities.

  • Consider the tax aspects of different bonds. By carefully comparing the after-tax rate of return for various bonds, you may be able to increase your return. Depending on the type of bond, interest income may be fully taxable or exempt from federal and/or state taxes.

  • Review your bond holdings periodically. Review the credit ratings of all your bonds at least annually to ensure the quality hasn't deteriorated. Make sure your holdings are still consistent with your overall investment objectives.


Seeking Alpha Certified
Creative Commons License
This weblog is licensed under a Creative Commons License.

Privacy Policy - Terms and Conditions - Site Map - About Company - Contact Us
Link to Us - Partners - Advertiser Center - Newsroom

© ManagingMoney.com. All Rights Reserved.
Image Domain - Las Vegas Web Design Services