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Today, saving for retirement brings more unique challenges compared to previous generations, as many companies used to offer pension plans that guaranteed retirement income. And, if you weren't lucky enough to receive a pension, there’s Social Security, which was a guaranteed lifetime benefit paid by the federal government from contributions of current workers. Many former retirees received both a pension and Social Security. But things are different today, at least for those who are not yet retired.

Many private sector employers are no longer offering pensions, and Social Security could be forced to reduce benefits over the coming decades. For those still working, and especially those just starting their working lives, the future is filled with uncertainty, so actively planning for your retirement is crucial.

One important question to ask yourself is, “How exactly do I want to live during retirement?” Do you want the freedom to travel the world to visit friends and family, or would you rather depend on a part-time job to make ends meet? The best way to protect your future is to start a disciplined retirement savings plan as soon as possible. If you are relatively young, you don't necessarily need a lot of money now to secure your retirement; you have something just as valuable—time.

The Power of Compounding

In order to grow wealth over a lifetime, one of the most important concepts to understand is compound interest. Compound interest occurs when interest is added to the principal, so from that moment on, the interest that has been added becomes the principal and also earns interest. 

If you saved $100 that earned 8% interest per year, at the end of the first year, you would have $108. During the second year, interest is earned not only on the first $100 but the additional $8, for a total of $116.64. That extra 64 cents may not sound like much, but over a lifetime, the effect can be substantial.

Here's an example: say you start saving $200 per month at age 22, and save until you are 65. If you earn the historical average stock market return of 8.5%, after 43 years you would not only have the $103,200 you saved, but you would have an additional $946,377.17. That's a total of over $1 million, all for $200 per month.

But what happens if you don't start saving until you are 40 years old, cutting your years of contribution and compounding from 43 to 23? Rather than over one million dollars, you would be left with a somewhat less impressive $167,000. Or what if you had simply saved $3,000 from a summer job each year during college and never added another dime? That $12,000 investment at an 8.5% return would be worth over $450,000 at age 65 all because of compounding—not bad at all.

These examples assume a rate of return that's based on past averages since nobody can predict the future, and they also assume tax-free growth in an IRA, 401(k), or similar account. But they do serve to illustrate an important point: by starting early, you can dramatically increase your returns by retirement.

The Consequences of Investment Fees

There is a time when compounding actually works against your overall returns, and that's when you include the management fees typical of many mutual funds. Also known as the "expense ratio," this fee can take a substantial bite out of your savings. A typical expense ratio for a mutual fund is 1.19%, meaning that 1.19% of your total balance is taken each year as a management fee. So if you had an account worth $100,000, you would be paying nearly $1,200 per year in fees regardless of whether you made or lost money that year.

The effects of this expense ratio are even more striking when you consider the damage done to long-term gains. In a previous example, someone who saved $200 per month for 43 years would have a nest egg of over $1 million, assuming historically average stock market returns. But what happens when you subtract an average management fee? Rather than $1,050,00, the total becomes just $721,000—a difference of $329,000, or 31%.

In addition to the expense ratio, some mutual fund companies charge a fee on the purchase and/or sale of mutual fund shares. The fee upon fund purchase is called a "front-end load,” and the fee on the sale of the fund is known as a "back-end load.” So in our example, putting our hypothetical investment in a fund with a 5% front-end load would reduce the total by approximately $72,000, leaving a total of $649,000. If the fund also charged a 5% back-end load, that would reduce the total by another $32,500, leaving a final balance of $616,500—that's a total difference of $433,500, or 41%, of our original example, all because of a 1.19% management fee and 5% front and back-end loads.

When evaluating investment options, pay close attention to the expense ratio and load percentages since they can make a much bigger difference than one would expect. 

Asset Allocation

Because each of the main three types of investment classes involves different levels of risk and reward, you will often hear the term "asset allocation" in regard to investment planning. Asset allocation simply means the percentage of your entire investment portfolio that is invested in each of the three main asset categories.

Younger investors, who have years before retirement, typically choose a higher percentage of stock ownership; this offers greater opportunity for growth but also more risk. As investors get older and preserving savings becomes more important than rapid growth, they may gradually transition to a majority of bonds and cash as they approach retirement.

If you’re looking to get started on your retirement planning or need to refresh your current strategy, we can help! First Harvest offer members the opportunity to connect with our seasoned financial professionals to help you make the most of your hard-earned money and provides guidance based on your savings goals. You can schedule a complimentary consultation with one of our representatives today to establish or revise your retirement and investment goals.