How to Invest for Retirement
Because most people no longer receive pensions, it is important to invest for retirement. The goal of saving for retirement is to stash away enough money so that you can live comfortably once your primary income is gone. Rather than making risky investments that have the promise of a quick return, it is best to make safe investments that will yield a return that exceeds inflation. There are several options for retirement investing.
Before Investing, Pay Off Debt
It is unwise to invest for retirement before paying off high-interest debt like credit card and personal loan debt. Pay off the debt with the highest interest first. Each month you keep a balance on your credit card, you add to that balance.
See Managing Personal Finances for more tips.
Save Money for Retirement
Saving cash is a safe way to accumulate money for retirement even though inflation erodes its value. Options for cash accounts include:
- Savings accounts: Financial institutions pay interest on the money in the savings account.
- CDs: CDs earn interest for a fixed term in an account insured by the FDIC at a bank or a savings and loan.
- Money market funds: Money funds invest in short-term and low-risk securities like Treasury bills, CDs, and commercial paper.
How to Invest for Retirement: Your Options
When investing for retirement, make sure to have an understanding of the potential risks and returns of each investment. While friends, relatives, and financial advisers may offer tips about investing, it is best to invest in products that you understand. Before investing in a product, consider whether the product is safe, whether the investment will grow faster than inflation, and whether taxes and fees apply to the investment.
Every investment has advantages and disadvantages. Here are some investment choices:
- Stocks: A stock represents a proportional ownership share in a corporation. The profitability of a stock relies on the increase of the stock's price. Profit, therefore, typically coincides with the growth and performance of the company. Consequently, a stock investment carries the risk of loss if the company fails. Corporate profits, though, tend to rise faster than inflation.
- Mutual funds: Professional managers of mutual funds pool money from shareholders to invest in various assets, such as stocks, bonds, and money market instruments. Shares owned by investors represent their ownership or equity position in the fund. Shareholders are free to sell their shares at any time, but the price of a share fluctuates daily. Mutual funds offer the benefit of diversification and the ease of converting the shares into cash, also known as liquidity. Mutual funds are subject to management fees.
- Bonds: A bond is a type of debt security. The issuer of the bond, typically the federal government, state and city governments, or a corporation, raises money through borrowing. A bond is a promise to pay the principal (the amount borrowed) plus interest by a specific date. Unlike stocks and mutual funds, the bondholder does not receive an equity interest. The advantages of bonds include the following: bonds are generally safer than investing in stocks because debt holders receive priority over stockholders in bankruptcy; bonds from the U.S. government are considered "risk-free;" bonds produce predictable returns; and interest rates for bonds are typically higher than what banks pay on savings accounts.
Diversify Your Investments
Diversifying investments will help reduce risk. The mixture of a wide variety of investments within an investment portfolio is a technique used to manage risk. When investing, consider the following:
- Take into account the risk and the return.
- Consider the costs of the investment product.
- Diversify by investing in stocks, mutual funds, bonds, and money market funds.
Should You Use a Financial Adviser?
Before deciding whether to hire a financial adviser to manage your retirement investments, it is important to consider how financial advisers earn compensation:
- Commissions: Commissioned financial advisers receive compensation every time an investor buys or sells an investment. In some cases, the adviser will receive additional compensation when an investor buys a particular investment product.
- Management fees: Some financial advisers charge a fee based on the size of the investor's portfolio.
Because financial advisers receive compensation through commissions and management fees, conflicts of interest often exist. Because bias may be present, be cautious when acting on the advice of a financial adviser.
Choosing a Financial Adviser
If you decide to use a financial adviser to invest for retirement, determine whether the adviser has a proven record of success, can provide references, and has the appropriate credentials. Verify credentials by checking for membership in a professional trade organization, determine whether the adviser is a Certified Financial Planner (CFP) or a Certified Public Accountant-Personal Finance Specialist (CPA-PFS), and request a copy of Part I and Part II of the Federal Securities Disclosure Form ADV (this document provides information about any legal and financial problems of the adviser).
Retirement plans offer a good way to create another source of income for retirement. Like other investments, diversify in order to balance some of the advantages and disadvantages of each retirement plan. Two types of plans are beneficial:
- Tax-deferred plans: Invest for retirement in a tax-deferred plan like a 401(k), 403(b), SEP-IRA or a traditional IRA. The income earned in the retirement plan is tax-free until withdrawn. Once withdrawn, it is taxed as ordinary income. In addition, withdrawals during retirement will increase a retiree's income, which may result in a tax on Social Security benefits.
- Non-tax-deferred plans: In a non-tax deferred plan like a Roth IRA, contributions are ineligible for a tax deduction but withdrawals during retirement are tax-free.
Consider speaking with a wealth-management firm or financial adviser if you have additional questions or concerns about how to invest for retirement.