Thursday, February 16, 2006

Life Without a 401(k)

News Analysis
February 16, 2006

Business Week Online

Life Without a 401(k)

No retirement benefits at work? No problem. Here are some fairly painless ways young workers can build a nest egg

It's hard to turn on the TV these days without seeing a commercial about world-changing baby boomers and their upcoming retirement bliss. But guess who's inheriting a future with diminished job stability, disappearing pensions and increasingly imperiled safety nets? Their children (see BW Online, 1/13/06, "Slow-Mo in D.C. on Retirement Issues"). Today's young professionals should start saving fast, because there's a good chance no one else will be watching over their investments during their golden years.

That's easier said than done. As companies cut costs, many twentysomethings now hold freelance, temporary, or contract positions that don't come with a 401(k) or another retirement plan (see BW Online, 12/23/05, "Temporary Jobs: Bah, Humbug?"). According to the Employee Benefit Research Institute, less than two-thirds of employees between 21 and 30 have access to an employer-sponsored retirement plan in 2003, vs. roughly three-quarters of workers their parents' age.

Most young people also have other financial concerns. The typical college graduate in 2004 had a debt of $15,162, nearly a two-thirds jump from 1993 (see BW, 11/14/05, "Thirsty & Broke"). Throw in housing and health care, and the costs really add up (see BW Online, 2/02/06, "How to Get Your Health-Care Coverage").

But enough with the excuses. Thanks to the power of compounding, a little scrimping now can grow into a hefty sum down the road. So how much should cash-strapped Generation Debt workers save, and where should the savings go? This Five for the Money finds ways that young workers without company retirement plans can squirrel away money for the future.

1. Open an Individual Retirement Account (IRA).
A 401(k) isn't the only way to get tax-preferred savings. IRAs provide tax benefits of their own, and come in two distinct flavors, traditional and Roth. Both are available from most mutual fund companies.

Many financial advisors recommend Roth IRAs, especially for young people. Investors can't put pretax funds into a Roth IRA, but qualified withdrawals are tax-free. The after-tax nature of the accounts makes them ideal for anyone who is presumably in a lower income-tax bracket now than they will be at retirement. However, if you currently earn $110,000 or more per year, you can't use a Roth IRA.

Some young workers may prefer a traditional IRA, which defers taxes until withdrawal. In other words, money goes into these IRAs on a before-tax basis, as with a 401(k). Depending on annual income, assets going into a traditional IRA may be tax-deductible, too. Contribute by Apr. 15 to take deductions for the 2005 tax year.

For savers below age 50, the annual contribution limit for either type of IRA is $4,000, enough for most young professionals. In 2008, the limit rises to $5,000.

Most experts recommend leaving contributions in an IRA until retirement. Early withdrawals typically carry a tax penalty, but there are exceptions for medical expenses, higher education costs, or a down payment on a first home.

2. Explore other savings options.
Plenty of young people worry about locking up their money in the long run. After all, they might need to crack their nest egg for weddings, children, or rainy days. So contributions to an IRA can be supplemented with savings outside a tax-favored retirement plan.

Meanwhile, self-employed individuals have access to a wider array of retirement-plan options (see BW 12/05/05, "A Perfect Match"). A Simple IRA allows contributions of up to $10,000 a year and can be established anytime between Jan. 1 and Oct. 1 by visiting a financial institution. "They're very easy to use, and you can put a ton of money away," says Terry Balding, a certified financial planner at Terry Balding & Associates.

The self-employed have access to the same types of plans used by big corporations. A one-person 401(k) or pension plan could make sense for those with high income. But the cost and hassle of maintaining these complex programs will be too much for most young professionals.

3. Make savings and investments automatic.
Once workers start saving, the best way to keep up the momentum is to ensure that it happens by default. "The biggest piece of advice, beyond 'start now,' is to use a 'set it and forget it' approach," says John Curry, managing director of retirement management with FundQuest.

Most mutual fund companies allow deposits into IRAs or taxable accounts to be made directly from another account via bank draft. Like contributing to a 401(k), setting up a systematic bank draft allows savings to pile up in the background, without requiring any further effort.

These days the details of investing can be automatic, too. Mutual funds called lifecycle funds aim to take out the legwork, and they're growing in popularity (see BW 07/26/04, "Funds That Adjust As The Years Go By"). These funds shift their asset allocation from stocks to bonds as they approach a certain retirement date. Assets in the funds have more than doubled since 2003, according to Financial Research. Products like the T. Rowe Price Retirement 2040 Fund (TRRDX ) and Vanguard Target Retirement 2045 Fund (VTIVX ) have earned praise for low fees and ease of use.

4. Investigate indexes.
Then again, fees are usually even lower for an index fund. Young investors are widely encouraged to invest primarily in equities, because of their longer time horizon. An index fund lets them reduce management costs while they do it.

A fund tracking an index like the big-cap Standard & Poor's 500 gives exposure to a broad array of U.S. companies. Fidelity Spartan 500 Fund (FSMKX ) has a low expense ratio of 0.1%, while the Vanguard 500 Index Fund (VFINX ) costs only 0.18% (see BW Online 2/8/06, "How to Kick a Fund's Tires"). S&P 500 funds are also tax-efficient, so they can be relatively painless even outside a tax-favored account like an IRA.

"The last thing you have to worry about at this point in your life is asset allocation, because you don't have a lot of money," says Patrick Doland, a financial adviser in Northbrook, Ill. "So let's get you in an investment vehicle to start out, and let's not overcomplicate it."

Index funds make sense for young people who are confident they'll remember to give their portfolio a tune-up once it reaches $10,000. Indexes can be volatile, so the risk-averse should either be prepared or consider other options.

5. Follow the 10% rule.
Financial advisers suggest workers save 10% of what they earn. That may sound steep, especially since the national savings rate sank into negative territory last year for the first time since the Great Depression. But it is possible.

On after-tax earnings of $30,000 a year, saving 10% would mean setting aside less than $60 a week. So give up a night on the town, or start packing your lunches and skipping Starbucks in favor of the office coffeepot.

The trick is to get your house in order first. Keep paying off those student loans, but don't necessarily pay them ahead of schedule. In many cases, if a student secures a low, fixed interest rate, it may be better to invest that money.

On the other hand, it's almost always smart to pay off credit card debt first. Only extremely risky investments would have a chance of overcoming the high interest rates credit card companies typically charge. Better yet, avoid racking up debt in the first place.

THE TIME IS NOW. Saving doesn't have to mean all work and no play. Young professionals might also want to set aside an extra 10% for future indulgences, if they can swing it financially. "This is a generation that likes to have toys, too," says Jim Ludwick, founder of MainStreet Financial Planning.

Most importantly, start saving. Not having a 401(k) shouldn't be an obstacle to a young person getting a head start on retirement.

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