It’s benefits month at the university.
Even when you are an expert on this material, it is still really hard to figure out what to do with retirement. There’s so much uncertainty. There’s so many choices. There’s so many things that need to be explained and defined before even trying the optimization process.
I hear that Jeff Brown at UIUC has a conference volume where he shows that 100% of the finance professors at a university got their retirement decision exactly wrong, losing thousands upon thousands of dollars. In their defense, the benefits package was totally messed up, but still… if finance PhDs are going by heuristics instead of actually running the numbers, what chance do the rest of us have?
My first year on the job I satisficed. I have no regrets because in the absence of satisficing I would have done nothing, which is much worse. But this year I decided it was actually time to run the numbers and try to optimize, or at least get a little closer to optimization. And, it turns out, I’ve been losing hundreds of dollars a year for making the wrong choice, and would be losing more and more as my retirement kitty gets bigger.
First big question: How much to save for retirement? To be honest, nobody really knows the answer to this one. Maybe someday I’ll go into more detail on this topic, but it’s currently beyond the scope of this post. If you want a number, go for 15% of income if you’re young and 20% or more if you need to play catch-up or want to retire early. There are a lot of calculators on the internet you can use, but they all require a lot of assumptions and even the best ones can only give you the probabilities of hitting certain ranges. Do play with them if you want a better idea of how these factors affect your future retirement.
Second big question (if you have a choice): Defined Benefit or Defined Contribution plan? Often there will not be a choice– you get whichever your company is offering when you start your job. We had to choose. A defined benefit plan is a traditional guaranteed income annuity kind of pension plan and a defined contribution plan is what we talk about now with 401(k)/403(b) plans, essentially what you put in + employer match and earnings is what you get out.
In some cases the DB plan will be a lot better deal and in some cases the DC plan will be what you want to take. Annuities in the form of a DB plan are really nice– guaranteed income for life. It’s like insurance against not dying before you run out of money. Sadly they’re beginning to go by the wayside. However, even if your firm offers a DB plan, you may not want to go with it. If you think there’s a chance your company could go out of business before you die, a DC plan might be lower risk. DB plans are insured by the federal government but you won’t be getting 100% of benefits if your company goes under. A DC plan belongs to you no matter what happens to your company. DB plans are generally pretty safe if your employer is a state or federal government… government doesn’t like reneging on promises to large voting blocs.
However, even government plans may want to sweeten the deal for you if you choose a DC plan and may give higher matches or other benefits to make the DC plan more attractive. In addition, if you have to wait years to vest for your DB plan and not for your DC plan, then that may also make the DC plan more attractive.
Note that if you take a DC plan you do not want to put your money in company stock. If they only offer a match in company stock or the match is higher with company stock, then take that match and sell the stock as soon as you’re allowed to. If there’s nothing else in the plan besides company stock… well, that’s a tough decision and makes an IRA more attractive depending on the match.
Third big question: How much to put into your DC plan? Generally, if your employer gives a match, you want to put in at least up to the match. The match is generally a 25%-100% guaranteed instant return on your investment. Not even Bernie Madoff could beat that. The amount you invest on top of that is going to depend on a number of things– the number you chose to answer the first big question, your options for savings vehicles (addressed below), and whether or not you’re ROTH/Traditional IRA eligible.
Fourth big question: How on earth do you invest your money in a DC plan? Answer: either pick a target date fund, set and forget. Or, pick the lowest fee general stock/bond index funds your employer offers. If you’ve got Vanguard as an option, you can go with their target date fund and you’re golden. If you’re stuck with something higher cost it may be in your best interest to recreate that target date fund with the low-fee general index funds offered by Fidelity or TIAA-CREF or whatever company is managing your employer’s retirement plans. If your employer doesn’t offer low-fee general index funds and you’re ROTH eligible, then put what you can in a Vanguard Roth outside your employer. Anything after that you can put in your 401(k)/403(b) in whatever crappy mutual funds or other funds they offer, since it is still tax-advantaged. If you are close to retirement, then you may also want to look into their fixed annuity options, but if you’re young you don’t want to go there (for one thing, the annuity company is more likely to go under in 50 years than it is in 20 years).
Other questions: Regular 403(b) or ROTH 403(b): This is about your income and diversification. Regular 403(b)s/401(k)/IRA reduce your taxes this year and allow you to be taxed on your earnings in the future. ROTH versions have you pay a higher tax bill this year, but you can withdraw the money and its earnings in the future tax free. If you think taxes are going to go way up in the future, ROTHs are a good investment. If your income is higher now than you think it will be in the future, getting that tax break now might be optimal. Probably you ought to do some of both if you have the option. I could give you a % to put in each based on your income, but I’d just be making crap up. Nobody can predict these things. Your guess is as good as any.
403(b) vs 457: Don’t do a 457 plan unless you work for the government. This is one of those things where the government won’t renege on you but a company might. If you DO work for the government, you can choose either of these. A big difference is that you can tap into the 457 as soon as you leave state employment no matter what your age, whereas a 403(b) can only be rolled into other retirement savings vehicles if you’re too young to tap into it. There are a few other small differences if you are older or need hardship withdrawals. This is something to contact your HR department about if you have questions. Also note that you can actually save in BOTH, if you have more than 16.5K floating around. For us there wasn’t enough of an advantage of one over the other, so we went with the one that had the best (lowest fee) companies administering it.
Next I’ll talk about the mistakes I made when I first set this stuff up and then the process I went through with my own university to make changes to improve my retirement savings.