Post #18 – The 3 biggest Retirement Planning Mistakes Made by Young People
I thought I would take a break from tedious investing concepts and write a lighter post. So instead, I give you my opinion on what, I think, are the three biggest mistakes that people in their 20s, 30s, and 40s make when it comes to retirement planning. There are undoubtedly many financial/retirement planning mistakes people make early in their working lives, but these three are the most common ones I see and are the most costly. Two of the missteps are actually financial choices regarding saving and the third is a simple investment choice that is easy to change.
The first mistake is one I have mentioned many times in earlier posts. It is starting your savings plan too late. As I have stated before, putting off your retirement savings plan early in your working life is the biggest mistake young people make. For some discussion on this topic that will drive the point home, read Post #4 where I discuss “The cost of waiting” to start saving. I also recommend you read Post #8 where I provide a table providing a guide for determining your required annual savings rates. This post also provides an example of determining your retirement savings goal and how your required annual retirement savings rate quickly increases if you delay your savings plan.
In our current era of conspicuous consumption, saving money does not seem to be a shared American value the way it was 40 years ago. The 2008-2009 financial crisis, hopefully, has changed that mindset somewhat. In any event, the second biggest retirement planning mistake I see young people make is “ramping up” their lifestyle after a big increase in family income.
I understand, after a big pay raise, it is hard not to buy newer and nicer things. Many young people start out their working lives with a lot of debt such as school loans and from buying their first car or house. They feel like they have been scraping to get by for years and they deserve to treat themselves. I have been there and I know how it feels. And I am not saying you should not do something nice for yourself or your family after a big promotion or to celebrate the final payment of a large debt. But you should keep this urge in check and not let it get out of control.
In my opinion, throughout your working life, maintaining a modest lifestyle and living well below your means is one of the most important steps in reaching your retirement savings goals. Also, as I have indicated in earlier posts, your savings rate is more important than investment returns. Adding any newly available cash flow to your retirement savings will not only turbo-charge your retirement savings rate, it will make you much more financially solvent. This will give you a good feeling about your future, not only for yourself but for your family as well.
In the mid-1990s both my wife and I experienced big pay increases through job changes. Also about this time my wife finished paying off her school loans. We directed virtually 100% of our newly available cash flow straight into retirement savings. We found that by taking this step, rather than making us feel deprived, it energized us to save as much money as possible each year as our final savings target got closer and closer. Of course, we had a crystal clear goal of retirement at a certain date which provided us significant motivation.
The third big mistake is paying too high fees (also referred to as expense ratios) for retirement mutual funds. Paying high fees on your mutual funds that hold your retirement savings is a big drag on the assets of younger investors. This is because young people have a lot of years before retirement and mutual fund fees compound every year along with your fund account balances. In the mutual fund universe expense ratios range anywhere from about 0.25% to as much as 3% of the assets invested in the fund (There are other costs associated with mutual funds such as transactions costs and spread costs, but the expense ratio is the only cost you can really control). Most retail mutual fund companies usually charge an expense ratio of between 1% and 2% of your assets invested. Minimizing these fees is very important.
Some people wonder whether you should worry about a 1% to 2% cost to your asset base. The answer is yes you should. Over a 25 year time span, the impact on a retirement account balance being charged a 2% expense ratio versus a 1% expense ratio is approximately 20%. For example, a person making annual contributions to a mutual fund for 25 years that is being charged a 1% average expense ratio could have a $600,000 balance. The same account being charged a 2% expense ratio will only have a balance of about $480,000. The same funds with the same annual contributions and investment returns; the only difference is the funds’ expense ratios. Most people I know could use the extra $120,000 in retirement.
However, if all your retirement savings are in your employer 401(k), the mutual fund fees you pay are outside your control. Your employer, in an arrangement with the 401(k) administrator, determines these fund fees. And 401(k) plans are notorious for having high mutual fund fees, especially the plans with smaller employers. That’s because 401(k) retirement plan administrators offer to provide their 401(k) plan administration services free of charge to the employer. Of course someone has to pay for this service. And that someone is the employee. The 401(k) plan administrator bumps up the expense ratios charged by the mutual funds included in the company 401(k) plan to pay for the plan costs. And these fees are paid by the company employees; taken directly out of employee account balances. Since 401(k) mutual fund fees are usually not negotiated, they tend to be higher than if you were to choose the same fund administrator as your Individual Retirement Account (IRA) custodian. The fund administrator knows you can shop around for your IRA custodian so these mutual funds tend to have lower fees. The message here is that every time you leave an employer for a new job, you should NOT move your 401(k) assets to your new employer’s 401(k) plan. You should move all previous employer 401(k) assets to an IRA where you can shop around for the custodian with the lowest mutual fund expense ratios. I will provide some thoughts on mutual fund companies in a future blog post.
To summarize, if you are in your 20s to 40s, doing the following will rapidly increase your retirement assets:
1. Start a serious retirement savings plan ASAP.
2. Later, if you get a big pay raise or pay off a large debt, try to resist taking on new debt. Funnel your new cash flow toward your retirement savings.
3. Shop around for an IRA custodian with the lowest fund fees.
In my next post I will provide my opinion of the biggest retirement planning mistakes that people in their 50s and 60s make.
Did you enjoy this post? Why not leave a comment below and continue the conversation, or subscribe to my feed and get articles like this delivered automatically to your feed reader.
Comments
No comments yet.
Sorry, the comment form is closed at this time.