The Key is to Start Now

We are often asked what young people – particularly Millennials, also known as Gen Y – should be doing to secure their financial future and save for retirement.

The answers are no different from what their parents and grandparents have done. But the key advantage Millennials have on their side is time. By saving and investing earlier in life than their parents and grandparents, Millennials will reap the rewards of the time value of money.

A 25-year-old who is able to invest $880 per month at a modest 5% growth rate will have $1 million by age 60. A person 10 years older would have to invest $1,680 per month, and a person 20 years older would have to invest $3,741 per month to get the same result. These numbers show the importance of starting early when it comes to saving and investing.

Who Are Millennials?

Members of the Millennial generation were born between 1981 and 1996 and number about 72 million people in the U.S. Approximately 31 million of them are between 25 and 29 years old today, and another 41 million are between 29 and 39.

Surveys in recent years have shown that Millennials are more likely than their older peers in Gen X or even Baby Boomers to seek professional guidance about saving and investing. That’s a good thing, because the younger you are the longer you can benefit from professional advice.

The tools of saving and investing for retirement are the same, regardless of age. But Millennials have a wider range of tools available to them since some investment vehicles and strategies carry more risk and are more appropriate for younger investors. That’s another advantage of having time on your side – there is time to recover when risks don’t work out.

But building a strong financial profile is about more than saving and investing. It’s about budgeting, paying off certain debt and avoiding the pitfalls that many young people fall into.

In Your 20s

  • Workplace Retirement Plans – Millennials starting out in the workforce should first take advantage of employer-sponsored retirement plans such as 401(k) plans, 403(b) plans and 457 plans (available to certain government employees). These plans offer the best opportunity for tax-deferred savings during a person’s working years. The percentage of salary deferred will depend on what the participant can afford and must be within limits set by the IRS every year. At the very least Millennials should defer the minimum amount of salary to qualify for an employer match if there is one. Employer matches can help retirement savings grow faster.How much salary should you defer? That depends on your age, stage of life, and goals for retirement. For most people in their 20s and early 30s, a 10% to 15% deferral would build a strong retirement portfolio over a 35- or 40-year work life. Workers who delay the start of their savings would have to defer a higher percentage to reach the same goals.
  • Roth IRA – One advantage Millennials have that was not available to their parents at an earlier age is the Roth IRA. A Roth allows investors who meet certain income limitations to set aside after-tax money and allow it to grow tax-free as long as the account is held for at least five years. Roth savers must wait until age 59½ to withdraw the funds, but that’s where the big payoff is – the withdrawals are tax-free.
  • Roth 401(k) – Employers who have 401(k) plans often include a Roth feature that allows participants to pay tax on the salary deferrals up front, so their distributions later are tax free. Unlike Roth IRAs, Roth 401(k) plans have no income limit. It’s important to understand that the employer match, if there is one, goes into the traditional side of the 401(k) plan and is taxable at distribution.
  • Avoid bad debt – Not all debt is equal. Borrowing for a college education or a house is fine, as long as you are cautious about interest rates and borrowing only within your means to repay. But “bad debt” is debt that carries high interest rates, such as unsecured credit cards. Again, it’s okay to have a credit card, but running up a greater balance than you can pay off within a month is a bad idea because the interest charges will pile up quickly. Some Millennials delay saving for retirement because they want to pay off debt – such as student loans – first. But they are passing up more than a 100% return by not participating in a 401(k) or similar plan. With careful budgeting, it’s possible to pay off debt and save for retirement at the same time.

The ‘Bucket Approach’

Portfolios require active management, and young investors should gain an understanding of what constitutes risk and what their risk tolerance is. Generally, young investors invest more aggressively than investors nearing retirement. When the market is down, it’s a great opportunity to buy cheaper shares. But as investors get older, they generally dial back the risk level a bit so the portion they need to live on in the next few years is not exposed to the same risk as the rest of the portfolio.

An ideal portfolio allocates the investments within three buckets.

  • Bucket 1 – This is the money you anticipate living on in the next five years. It should be in highly liquid, conservative investments such as money market funds, short duration bonds and savings accounts.
  • Bucket 2 – This is money allocated for years 6 through 10. It’s more aggressive than Bucket 1 but invested with moderate risk. Investments include bonds, annuities, preferred stocks and investments with moderate risk/return.
  • Bucket 3 – This is the money that is invested with long term goals in mind. Even retirees need funds allocated to Bucket 3 as they can live in retirement 20 or 30 years. Equities in this bucket can carry as much risk or as little risk as you have the personal tolerance for. Generally speaking, the greater the risk, the greater the rewards. Taking excessive risk can lead to losses for those who aren’t careful. With that said, downturns and market corrections can present opportunities for smart investment to buy stocks that have fallen in price.

According to the U.S. Bureau of Labor, 78% of civilian employees with access to workplace retirement plans participate in them, and 89% of state and local government employees participate. Millennials are showing a heightened awareness of the importance of retirement saving, compared with older generations, and they have the potential to push those participation rates higher.

If you have questions about how to start a strong personal retirement savings plan, contact your Adams Brown wealth consultant.