Conventional wisdom tells us that saving for retirement begins early in life with consistent contributions to a diversified portfolio that will allow the market to grow the funds over a long-term investment time horizon. The traditional view of retirement savings says: save early, save often, invest in stocks, and diversify according to your risk tolerance and eventually you will be able to retire. This strategy is based on four basic concepts: spend less than you make, pay yourself first, invest in equities for long-term growth, and diversify your portfolio according to risk metrics. This overly simplistic view ignores the unique challenges investors face at different phases of life. Telling young investors to save consistently is futile if they don’t have excess funds to save. Additionally, effective savings eventually creates a portfolio so large that investment selection matters more than savings rates. This growth closes the gap in retirement savings (because of missed savings early on) and brings one’s retirement date closer, while also increasing the need for an investor to protect the portfolio’s gains. These unique phases can be divided into the four groups: income, savings, growth, and protection.

Traditional View

First, let’s review the traditional view of savings. Early on, saving can be difficult, especially for young people in the early stages of their career because there may not be additional funds to save. Income, spending needs and the ability to save vary greatly throughout an individual’s life. For example, raises and promotions, starting a family, and children moving away from home are just a few examples of why steady, consistent retirement savings are not realistic.

Eventually, as income increases, savings opportunities will also increase. Even in this stage, contributions to the portfolio outweigh market growth. Investors can still afford to take significant risk but more years than not, portfolio growth will predominately come from savings rates.

For people that have saved adequately, the size of their portfolio will at some point yield gains that largely outweigh their contributions because of the compounding growth. This, of course, assumes that they are invested the right way. Allocation now matters more than it did before and, while investors in this group may know the right amount of stocks and bonds for their risk tolerance, they often have no idea what the right mix is to achieve their goals. As these investors get close enough to their retirement date to be concerned about market losses, their investment allocation becomes even more important. Preserving the assets should be their primary concern, even ahead of maximizing growth. Hence, investment returns and risk management goals vary greatly over time as well. Early on, young investors have such a long time horizon to invest they can take on significantly more risk in their portfolio. Conversely, in later years, seriously adverse market conditions could potentially derail a retirement plan regardless of how well someone has saved.

This approach to retirement savings is typically divided up into two groups: accumulation and consolidation. In this framework, accumulation begins in the investor’s early earnings years and continues until about five to ten years prior to retirement. The last phase is consolidation. This is when most people begin to think seriously about retirement and subsequently, their investments.

Today, this language is largely inadequate to address the various obstacles facing investors and leaves many individuals feeling uneducated and confused about how and when to save. As previously mentioned, dividing retirement savings into four distinct phases can help to explain the reality of retirement planning: income, savings, growth, and protection.

This framework is also important for financial professionals, not just their clients. Planners must work as educators because no matter how much investment experience or money a client has, they are often mentally unprepared for how to save based on their current life stage. As planners it’s paramount that young clients understand that they should be focused on maximizing earning potential and rates of savings, not rates of return. Clients in their highest income years should be saving but also investing their funds for growth. For clients close to retirement, whose income is largely stagnant, contributions to investments can be wiped out in a few months without the proper risk mitigation strategies in place. So what does retirement planning really look like?

Income

In the first phase of retirement planning, for people in their 20’s and early 30’s, the most important question is: “Can you afford to save for retirement?” Is there free cash flow in your budget on a monthly, quarterly, or annual basis? Overspending income is not unique to young investors. As a planner I have worked with clients that make less than six figures and still manage to save large amounts of money annually. I have also worked with clients that make hundreds of thousands of dollars and still spend more than they make. However, the reality is, for people just getting started there may not be any room to cut back on spending because of housing and food costs or, more commonly, student loan debt. The conventional wisdom for people in this position is to spend less and save more. This doesn’t work when it isn’t possible to spend less. Better advice for these investors is to earn more to save more. This can mean taking on a second job, investing in additional education or training, or looking for a more lucrative position. The bottom line is that people in their 20’s should be focused on growing their earning potential.

Savings

Once income is large enough to support making consistent savings (investors in their 30’s and 40’s) many people make the mistake of succumbing to lifestyle inflation. At this stage there is more than enough to cover expenses and debt and many people begin to spend money on things they have gone without in the past. The challenge facing this group is not whether or not they can save but whether or not they do save. The prospect of spending additional income is very attractive, but additional dollars must be committed towards savings goals at this stage. The concept of earning more and subsequently spending more is often referred to as lifestyle creep, because the additional spending tends to “creep” up on families. It’s very common for people at this stage to wonder where the additional income has gone; more often than not, they don’t even realize where it’s going, they only know that there never seems to be money left at the end of the month. Success in savings during this phase can be achieved by developing habits that facilitate savings. Parkinson’s Law states that, “Work expands so as to fill the time available for its completion.” The corollary to Parkinson’s Law is that spending will expand so as to exhaust what is in the checking account. Typically, excess discretionary spending can be eliminated just by moving a set amount of money to an account that is “out of sight” and therefore out of mind. Outcomes at this stage are driven not by the financial capacity to save, but rather willingness to engage in savings behaviors.

Growth

Now that saving behaviors are consistent, time will work to grow the portfolio and the dynamics shift. For people in their late 40’s and 50’s, eventually the balances grow so that market returns largely outweigh annual savings. After 10 years of regular contributions account growth is roughly made up of 50% gains and 50% contributions. After 20 years 75% of growth comes from gains and after 30 years 90% of the annual increase comes from the market. Practically speaking, after several decades of consistent savings behaviors, the savings behaviors themselves become a secondary force in accumulation. At this stage, portfolio growth is the primary driver of success. Put differently, in the early stages of retirement planning 1% of growth is relatively meaningless compared to a regular contribution, while at the end of retirement planning a 1% increase in the portfolio can be extremely meaningful due to the size of the account. As a portfolio grows it becomes increasingly important to pay attention to how the funds are invested, as well as how much one is paying for investment advice. Is the allocation geared for growth? Is there adequate downside protection? Are active fund managers providing the appropriate value for their cost? How are all of the costs of the portfolio being managed? Specifically, at this phase it is increasingly important to pay attention to the details of the investment strategy.

Protection

As people approach their 60’s, near the end of retirement planning, everything changes again. The short time horizon until funds will be needed takes the focus away from volatility and puts it on the risk of a significant market drop. A large decline in the market in the years leading up to retirement could completely derail even the best thought-out retirement plan and force an investor to postpone their retirement date.  This is called “retirement date risk.” The bottom line is that protecting the portfolio and managing risk should be the primary focus of an investor approaching retirement. However, in today’s retirement paradigm, where retirement can last over 30 years, risk cannot be completely removed from the portfolio. The “other guys” guard against retirement date risk buy slowing moving investments from equities to fixed income. Unfortunately, due to lack of market knowledge, many investors end up with fixed income securities that behave like equities. Alternatively, some investors use variable annuities with income riders to achieve downside protection. These investments are illiquid and have high costs. A less common strategy would be to buy options to mitigate risk. This is a sophisticated strategy that many investment professionals lack the training to execute. The least common strategy, used by Gainplan and other tactical money managers, is to take funds out of the market to reduce downside exposure and avoid loss. Regardless of the methodology used, success in the final years of retirement planning has less to do with saving and generating market growth and more to do with avoiding severe losses in the portfolio.

What If I Am Off Track?

The natural inclination for most investors is to assume that they are off track. A qualified financial planner can help you determine if you are progressing towards your goals, and if not, what steps need to be taken to get back on track. It can be incredibly difficult to determine on your own, not just because personal financial planning is extremely complicated, but also because most advice is not suited to individuals and the obstacles that they are facing. When we meet with new clients it’s common for them to have felt frustrated with financial advice they have gotten in the past.

Effective advice for any savings goal will vary over time and it’s important to receive personal advice. Not only because personal recommendations will ensure a higher chance of success, but because personalized service will help you to know if you’re on track. Many investors don’t engage in healthy savings behaviors because they feel unnecessarily guilty about the current state of their finances. In summary, for people in the income phase it’s all about increasing income to a point where saving is possible. In the savings phase, it’s about determining when to start and how much to save. In the growth phase, the focus should be on investment strategies, and in the protection phase it’s about managing risk. It’s essential to keep in mind where you are and what you should be doing to achieve your goals. 

This commentary on this website reflects the personal opinions, viewpoints and analyses of the Gainplan LLC employees providing such comments, and should not be regarded as a description of advisory services provided by Gainplan LLC or performance returns of any Gainplan LLC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Gainplan LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.