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THE ACCUMULATION YEARS

Develop a Budget for Short-Term and Long-Term Goals and Stick to It

Understand Sources and Projected Amounts of Retirement Income

Develop an Investment Strategy

Quantify the Retirement Income Gap

Develop a Budget for Short-Term and Long-Term Goals and Stick to It

Developing a budget and sticking to it may be one of the most difficult challenges for most people.  Many people think that preparing a budget is so complicated that it requires assistance from an accountant or a background in accounting.  Plus, sticking to a budget requires a lot of self-discipline -- especially if you're not used to watching your finances.   After reading this, we hope that you will be able to overcome both of these obstacles.

First, let's see how easy it can be to develop a budget.  A budget is simply a listing of your income and expenses which ensures that you have enough income to cover your expected expenses as well as sufficient savings to cover any large purchases or emergency expenses. Borrowing the funds may be an acceptable alternative -- as long as you remember to budget the additional interest expense associated with borrowing. Remember, you need to take control of your money.  Don't resort to unplanned borrowing unless you have no other alternative.

If your expenses exceed your income, you may already be in trouble.  This means that you already have to borrow money just to meet your ordinary living expenses.  If your income exceeds your ordinary living expenses, you should be able to invest this amount in your savings program.

Once you have established whether you can invest in a savings program, you should make a list of your short-term and long-term goals.  For example, your short-term goal may be to purchase a new automobile within the next two or three years, or to establish an emergency or contingency fund to cover unexpected expenses.   As a rule of thumb, your emergency fund should equal three to six moths of your ordinary living expenses.  Your long-term goal might be to retire at age 65 with the same standard of living you enjoy today.

After setting your short-term and long-term goals, you will have to adjust your goals (either the timing or the amount), or adjust your budget.  Your goals and budget will be continually changing.  But as you can see, developing a budget doesn't have to be difficult.  Since we assume that you really want to attain your goals, we believe that you will find the necessary discipline to stick to your budget.

Understand Sources and Projected Amounts of Retirement Income

Let's assume you want to retire at age 65.   What are you going to live on after you retire? Hopefully, you will have some savings -- but will you have enough?

Before you can quantify how much you need to have in savings at retirement, you need to understand the sources and projected amounts of your retirement income.

Possible sources of retirement income include:

* Employer-provided pension plans

* Employer-provided savings plans

* Social Security

* Non qualified retirement plans

* Savings (investments)

Employer-provided pension plans. If you have a pension plan, you are generally entitled to an annual pension or income when you retire.  These benefits are typically based on a formula that includes your length of service with the employer, your age at retirement, your annual Social Security income, your pre-retirement earnings, and whether you elect to take a pension based on your life expectancy or for your and your spouse's life expectancy.  In some cases, you may be able to take a lump sum at retirement instead of taking an annual amount.

Employer-Provided Savings Plans.  Many employer-provided savings plans permit the employee to elect to contribute a certain percentage or a certain amount of pre-tax income to a retirement savings account. In some cases, these plans also allow post-tax contributions.  Many employers (but not all) make ''matching'' contributions in cash or employer stock to subsidize these accounts.  Under the terms of many of these plans, you may have significant, if not total, responsibility for investing your contributions.  (Click here to learn more about developing an investment strategy for your funds.)

Understanding the importance of electing the maximum contribution amount to these savings plans cannot be overstated.  Anytime you have the ability to contribute pre-tax (or post-tax) income to an account which will grow at a tax-deferred rate, you should do so unless you clearly can't afford to do so.  (Presumably you would have a very important reason for not participating.)  To the extent, your employer matches any portion of your contribution, it becomes even more important to contribute.  Receiving an employer match is same as receiving an annual increase in pay.

Non Qualified Retirement Plans.  Almost any plan designed to increase an employee's retirement income or savings available for retirement can be considered a non-qualified retirement plan. These plans can be provided by an employer, or established by an employee. Because these plans are non qualified, employers who provide these plans do not receive any income tax deduction until the funds are actually paid to, and subject to tax by, employees. Until the funds are paid to employees, there is some risk that the funds will not be available to the employee at retirement.  If you participate in this type of plan, you may want to consider this risk when determining your projected retirement income.

There may be less risk with employee-funded non qualified retirement plans, but there is still generally some risk.  For example, if you purchase a deferred annuity or a cash value life insurance contract for tax-deferred growth, there is still some investment risk, as well as the risk that the company selling the products will not perform as well as expected.

Social Security.  There is a lot of skepticism as to whether younger workers will ever receive any Social Security income.  In fact, many financial planners do not even consider Social Security in their sources of retirement income.  As a general rule, if you are in your thirties or forties, you may not want to assume that you will receive any Social Security income.  If you develop a budget without including any Social Security, you are only being conservative.  If the laws do change, you will be ahead of the game.  If Social Security is still around as you get closer to retirement, you may have the opportunity to change your goals (maybe even retire earlier), investment strategy or budget.

The formula for determining your Social Security benefit is similar to the formula used to determined employer-provided pension benefits. The primary differences are that Social Security income is never available in a lump sum, and as a general rule, the maximum annual amount payable is generally much smaller than the amount provided under an employer-provided pension.

Savings (Investments).  You have learned about budgeting and how any excess income can be considered savings.  Now, we will discuss how you could develop an investment strategy for your savings.  Once you assume how much you will be saving each year and how much your savings should increase each year, you can project the amount of savings you will have at retirement.

How To Compute Your Retirement Income.  Before you can determine whether you have a retirement gap, you will need to convert all sources of your retirement income to an annual income stream (adjusted for inflation). This is easy for those sources that are already expressed in annual amount, such as your employer-provided pension and Social Security benefits.  However, your other sources of retirement income need to be converted from a projected lump sum at retirement to an annual amount (inflation-adjusted) that will be available until the death of you and your spouse.

Develop an Investment Strategy

At this point, you have established some short-term and long-term goals.  You have also developed a budget which will assist you in attaining those goals.  You are saving any excess income in an emergency fund or another savings account so that you will have the cash when you need it.  You have established a goal to retire at age 65 and you know your projected retirement income.  But how much do you need to save and how much does this amount have to grow if you want retire at age 65? These questions reflect the importance of a sound investment strategy.

Starting Out.  Initially, your investment strategy will be relatively simple.  For example, until you have a sufficient amount in your emergency fund to cover three to six months of expenses, you will want to invest most of your excess income in investments that are liquid and risk-free.  Because these funds need to be available for unexpected expenses, you will generally invest them in cash and cash equivalents.   Examples of cash and cash equivalents would be savings accounts, money market accounts, certificates of deposit and U.S. Treasury bills.

Accumulation.  At the other end of the spectrum is the investment strategy that you should develop for the funds in your employer-provided retirement accounts.  At this point in your career, you probably don't intend to use any of these funds for at least ten to twenty years. Because you have a long time horizon, you can accept some risk knowing that, at least historically, this risk should provide you with a greater reward over the long term.  Based on these parameters, your retirement accounts should be more heavily weighted toward stocks and bonds as opposed to cash and cash equivalents.

Positioning.  Once you have the necessary balance in your emergency fund, and you are contributing the maximum amount to your employer-provided retirement accounts, any additional excess income should be deposited into an investment account (your investment reservoir).  This is the point where you need to start thinking about asset allocation.   In other words, you need to decide what portion of your excess income should be invested cash and cash equivalents?  What portion in stocks?  What portion in bonds?

Your asset allocation will depend upon your particular facts and circumstances (e.g. your age, your goals). Typically, your asset allocation should be more heavily weighted toward cash and cash equivalents and bonds in the beginning -- especially if you have a lot of short-term goals.  As you accumulate more savings you will generally be able to invest a higher percentage in stocks.

Quantify the Retirement Income Gap

You have established a long-term goal that you want to retire at age 65 and that you want to maintain the same standard of living in retirement as you have now.  If your ordinary living expenses are currently $40,000, you will have to make an assumption as to whether this amount, adjusted for inflation, is the amount you want to project to retirement.  You may not have certain expenses (work clothing or home mortgage) but you may have others (travel). Financial planners frequently assume that you will need 80% to 100% of your current ordinary living expenses adjusted for inflation at retirement.

For example, if you need $40,000 in today's dollars when you retire in twenty years, and the assumed inflation rate is 4%, you will need approximately $88,000 to cover your ordinary living expenses in the year you retire.  You have now quantified your retirement goal:  You want sufficient resources (retirement income, savings) to spend $88,000 (adjusted for inflation) during each of your retirement years.

Now you have to determine whether you have a retirement gap.  A retirement gap is the projected annual shortfall you would have when you retire because your projected retirement savings and income are insufficient.

Remember, all retirement income sources must be converted to an annual income stream. For example, let's assume that your projected annual income stream in retirement was $85,000. Since we have projected your annual retirement income ($85,000) and your annual retirement expenses ($88,000), we now know that you have a retirement gap of $3,000.

Because you have a projected annual retirement gap of $3,000, you need to do one or more of the following actions:

* Reevaluate your retirement needs to consider which, if any, projected costs can be reduced.

* Modify your current cash flow to build additional savings in company plans or on your own.

* Adjust your investment mix to try to increase the return on the assets you have available for retirement.

* Delay your projected retirement date.

The inflation rate is beyond your control.  If the actual inflation rate is less than the projected inflation rate, you may also avoid the retirement gap.

If you do not project a retirement gap, you will need to evaluate whether you have a sufficient cushion to add short-term or long-term goals or to "leave well enough alone" and continue with the same assumptions until you update your projections.  Generally, the farther you are from retirement, the more you should think of any excess income projected in retirement as cushion. Your projections should be updated, or at least verified, periodically to make sure that there have been no material changes in your retirement assumptions.

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