As I previously discussed in the Guide to Personal Finance for Physical Therapists, saving for retirement is a vital part of a sound financial plan. As an early career physical therapist, it can be just important to think about how you will prepare now for the future as it is to plan out your CEUs and fast track to clinical specialist certifications!
Current retirees get their income from a variety of sources, including Social Security income from the government, pensions from a former employer, and distributions from personal or employer-sponsored retirement savings plans. As young therapists, far fewer of us have access to pensions that will guarantee a certain income stream in retirement. This makes saving to fund our own futures far more important!
Understanding your 401k or 403b Plan
Most employers offer a tax advantaged savings plan, usually known as a 401k or 403b plan. If you're wondering where those odd number/letter combos come from, they refer to the sections and paragraphs in the IRS tax code that allow for these retirement plans! 401k plans are typically available to for-profit companies, while 403b plans are similar but for non-profit organizations like many schools or hospitals.
These retirement accounts come with multiple benefits. First, they provide tax advantages. Contributions to these accounts are considered salary deferrals, which means that you don't have to pay taxes before you invest the money. This is in contrast to traditional taxable investing, where you pay taxes prior to investing, then pay taxes again on the gains your money makes! If you invest in a tax deferred plan like a 401k or 403b, you pay less taxes now in exchange for letting your money grow for several decades. In retirement, you do still have to pay taxes when you withdraw the money.
Your employer may also provide a matching contribution to your retirement plan. For example, many employers contribute 50% of every dollar up to a certain percent of your salary, like 6%. If you make $100,000 per year and contribute 6%, you will defer $6000 from your salary and your employer will add $3000. Other employers match up to a certain dollar amount per year. For example, a company might match 50% of your contributions up to a match of $4000.
Deciding your Contribution Level
How much should you contribute every year? At the very least, contribute enough to gain the maximum employer match.
But ideally, you would contribute as much as you can now. Investing now gives your money more time to compound and grow! See this chart and description from Fidelity, a well-known investment firm:
The contribution limits for 401k and 403b plans are $18,000 per year for 2016. As young therapists, we have many competing financial goals: student loans, down payment savings, retirement investing, weddings, and travel, just to name a few! I will touch on these competing goals in future posts. But for now, think big: how much can you afford to save? It can make a huge difference in the future!
Risk Tolerance and Asset Allocation
So now that you've decided how much to invest, what do you actually invest in?
Good question! But I can't answer that quite yet. First you must determine your risk tolerance. Investing always comes with some degree of risk. You hope to make money, but there's always the possibility that you will lose money, too. Think about the recession of 2008-2009, for example. The S&P 500 lost almost 50% in 2008, which is a very real risk of investing. But looking at the history of the stock market for the past 20 years, you can see that there are rises and falls, but the general trend continues to go up!
With that said, what is typically recommended is holding a mix of stocks and bonds. Stocks tend to be more volatile--they offer a much higher reward in the form of increased value, but they also have a higher chance of losing value. Bonds tend to be more stable, without the high returns or high losses of stocks. As young adults, we have the luxury of having more time on our side before retirement, which allows us to take more risk. For a new investor, an allocation 80% stock and 20% bonds can provide a healthy return without the total volatility that a completely stock portfolio might create. I recommend taking a quiz like this one to determine your tolerance for risk before choosing your investments.
Choosing the right asset allocation will help you stay on track with your investments. If you choose an allocation that is too risky, you might find yourself selling your investments when they lose value. That is actually the the worst possible time to sell, as you lock in your losses without giving the investments a chance to regain their value! On the other hand, if you choose an allocation too conservative, you might find yourself regretting it down the road when your portfolio has not grown as much as it could have. Take some time to think about your risk tolerance and asset allocation. After contribution amount, it will have probably the biggest effect on your success as an investor.
Understanding the Funds Available in Your Plan
The information provided for each fund available in your workplace plan will include a few key pieces of information: the type of fund, the expense ratio, and the average returns of the fund. While it may seem like it would be the most important, the past returns are actually not a good way to pick a fund, as the performance in the past does not necessarily predict the future. I would recommend considering the expense ratio more highly in your choice. This number refers to the cost of administering the fund, and higher fees can have a huge impact on your eventual retirement income, as shown in this graph from Bogleheads:
Most plans have Target Date funds available. These funds are an already diversified mix of stocks and bonds, usually with international funds mixed in as well. They are usually named by the year in which the owner might retire: Target Date 2055, for example. These can be a good option, but make sure to pick the one that matches your particular asset allocation, which might not necessarily be the one that corresponds to your estimated retirement date. Also look at the expense of these funds, as you may be able to replicate them with cheaper index funds also available in your plan.
Index Funds are a very good option for all investors, especially new ones. Rather than trying to beat the overall performance of the market, index funds track the market, giving you the gains or the losses that the general market sustains. Another advantage of index funds is that they tend to be much cheaper. You can create a simple yet diversified portfolio with only a few funds--a total US stock market fund, a total bond market fund, and a total international stock fund.
For example, a 80% stock/20% bond portfolio with 30% of stocks in international could look like this, using Vanguard Funds:
20% Vanguard Total Bond Market Index Fund VBMFX
24% Vanguard Total International Stock Index Fund VGTSX
56% Vanguard Total Stock Market Index Fund VTSMX
Your plan might not have access to these funds, but it might offer other similar funds with which to create a balanced plan.