Enforced discipline is key to ensuring you’re saving enough to meet your needs, says Morningstar director of personal finance Christine Benz.
Video Transcript
Jason Stipp: I’m Jason Stipp for Morningstar. If one of your New Year’s resolutions was to save more for retirement, we have some tips to help you with that. I’m here with Morningstar’s Christine Benz, our director of personal finance.
Christine, thanks for joining me.
Christine Benz: Jason, great to be here.
Stipp: Investors often obsess about this fund or that fund? A Roth IRA or traditional IRA? But really the thing they should be obsessing about is how much they are saving every month.
Benz: That’s right. We maybe feed the obsession with all of our work on investment selection and tax management and so forth. But when you look at the most impactful things you can do for your portfolio plan and to help yourself reach your goals, the main thing you can do is try to bump up your savings rate. That’s going to be by far the most impactful thing when it comes to your bottom-line return.
Stipp: You often hear, every little bit counts when you’re saving for retirement. You brought an example of how saving just a little bit more can actually have a big impact if you have a long time before you retire.
Benz: If you have compounding on your side, you really can make those small sums work for you very, very hard.
If you are a 21-year-old, for example, and you’re able to save $100 a month, and you earn just 5% on your money, which I think is a reasonable rate of return to assume, and you save all the way until retirement, until you’re 65, you'd have about $200,000 when you turn 65.
If you are someone who is able to kick in maybe $50 more per month--just save $150 a month up until age 65 assuming that same rate of return, you'd have $300,000. So those small amounts, if you can find them in your budget, can really be quite impactful, especially when stretched out over a long time horizon.
Stipp: Small amounts can help, and getting started as soon as you can also sounds like a big help.
Benz: Absolutely.
Stipp: You have a few ways that you might be able to bump up your savings rate--a few ideas for people who are looking for some money to invest. The first one is a chunk of money that most folks get between now and April, which is their tax refund.
Benz: That’s right. A really large segment of U.S. taxpayers do get refunds. Roughly eight in 10 people get some kind of a refund. About $2,800 is the average size of a refund, but that does get skewed by some very high income taxpayers who receive very large refunds. When you look at refunds for folks in the lowest income tax bracket, the average refund isn’t anything to sneeze at. It’s about $2,000. So, when you think about investing that sum of money, especially if you have a long time horizon and can do it, say, over a 40- or 45-year period, you can end up with a significant savings amount that can turn into a pretty nice chunk of change over time.
Stipp: The nice thing about the refund is, in some ways, it’s forcing you to save along the way because that tax refund money is essentially yours, but the government is kind of saving it for you.
Benz: That’s right. When you look strictly at the numbers, you see that really you should not be giving the government this interest-free loan throughout the year, but for a lot of people, I think it is kind of an enforced savings plan.
The nice thing about refund season if you are inclined to save is that it also coincides with IRA season. You have until April 15 to fund your IRA for the 2014 tax year. So it’s a nice thing to do if you can tie those two things together: steer at least a portion of your refund into an IRA at the same time. That can be a great way to tick up your savings rate.
Stipp: And if you’re lucky enough to be getting a raise this year, before you go out and spend that or get a little bit higher standard of living, maybe think about saving at least part of that raise.
Benz: Right. We’ve come through this period of wage stagnation for a lot of workers. We’re starting to see some indications that that may be changing, that more people may in fact be in line for raises in 2015. That’s great news, and it is a great idea to think about steering a portion of that raise to your investment program. One of the most seamless ways to do it, if you are also contributing to a 401(k), is to bump up your contribution at the same time you anticipate that raise. That way you don’t get used to that higher paycheck because you’re steering at least a portion of it into your 401(k) plan right away.
Because this is such a beneficial way for workers to increase their savings rates, a lot of companies do employ a feature in their 401(k) plans called “auto-escalate.” It’s just a box that you’ve got to check on your 401(k) plan website, or whatever system you use to enroll, and that will automatically steer a predetermined portion of every raise you receive into your 401(k). So that can be a nice way to say, I’m going to continue to increase my contributions and do so with a lot of discipline.
Stipp: We know how easy it is to spend a little bit more when you make a little bit more, so the sooner you can do that probably the better.
Another area where people sometimes are able to free up some cash is by refinancing, and investing some of that money could be a way to bump up your savings.
Benz: Absolutely. One silver lining we’ve seen with low interest rates right now is that mortgage rates have been dropping. The typical rate is now around 3.65% on a 30-year loan. So we’ve seen a lot of people queue up to refinance. Of course, standards are still pretty stringent on refinancing, so not everyone who wants to has been able to refinance. But for those who do, that can be a nice way to free up some extra income in the household that you in turn can shuttle into your retirement savings plan.
When you think about someone refinancing from, say, a 4.5% 30-year loan into a 3.75% 30- year loan, assuming a $200,000 mortgage, that can free up an extra $100,000 into the household that in turn can be steered into an IRA or some such savings vehicle.
Here again, I think that idea of enforced discipline [to invest those mortgage savings] can be a really valuable thing. Any fund company or brokerage firm will let you turn on automatic contributions. They really like when investors invest this way, so they make it easy. Think about using one of those automatic investment programs, whereby you’re just saying take this amount out of my checking account every month and do it until I tell you to stop. Most investors, if they do set up a plan like this, don’t stop it. They tend to stick with it. So, it’s a nice way to increase your savings rate and keep it up.
Stipp: Another option that could be beneficial for your retirement, related to refinancing, is to refinance into a shorter-term loan, which you might really be happy that you did when you reach retirement?
Benz: I like this strategy a lot. One thing to keep in mind is that the interest rates on shorter-term loans will typically be lower than they are on longer-term, 30-year loans, for example. So if you can refinance into, say, a 15-year loan from your old 30-year loan, you may in fact pay right around the same amount that you were paying with that old loan, but you‘ll shrink the time period over which you’ll pay that sum.
So, as you say, that can be a really valuable thing for people who are gearing up for retirement. Certainly in talking to our Morningstar.com readers over the years, many of them have said that one of the best things they did for themselves was to plan to come into retirement debt-free. So if this describes your situation, shortening that loan term can be really beneficial. But truly, it can be a great strategy for investors at any life stage.
Stipp: Savings may not be the most dynamic topic to talk about, but it’s so, so critical. Thanks for joining me with those tips today.
Benz: Thank you, Jason.
Stipp: For Morningstar, I’m Jason Stipp. Thanks for watching.
