Expert: Paul Henneman - 1/23/2007

Question
I need some guidance:  my wife and I are in our mid-40's and would like to start a serious investment program for retirement years.  Goals are (1) security (2) long term growth and (3) tax shelter/defer until retirement.  We expect to be able to save/invest perhaps $1,500/month maybe a little more.  Government bonds or bond funds seem the most likely route to take, but not sure if the long term growth will keep up with inflation over the next 20 years or so.

Answer
Joel,
  Thank you for your question!
  I apologize for the delay in replying, I did not receive the usual notification that I had a question pending. I hope my answer will still be of use.
  There are essentially to ways I like to look at retirement and investment accounts: the actual investments, and the vehicle or format that you use to set up those investments. Let me start with the second one, which is directly related to your question number three.
   There are several ways that you can invest that offer tax benefits. Over time, these tax friendly ways to invest really make a big difference. The most common is a 401k plan through your place of work. Some employers offer this, some don't. The larger the company you work for, the more likely it is that they offer a 401k retirement plan. The benefits are that any contributions you make are 'pre tax' dollars, you do not pay income tax on what you put into the 401k each pay period.  The downside is that there is typcially a very short list of investments that you can put your funds into in the average 401k plan. To make matters worse, those investments are typically not very good ones. There are good 401k plans out there, but most do not have the best selection of stocks or mutual funds to put your money into.
  However, the tax advantage is so beneficial that it still makes a great deal of sense to invest in a 401k. If you have access to one, I would look into it. If there is a general index mutual fund in the 401k plan, great. More on index mutual funds later.
   If you do not have access to a 401k plan, the next best thing would be to set up a Roth IRA account, or standard IRA account. IRA stands for "Individual Retirement Account". If you work does not offer a 401k, you can actually tax deduct each year your contributions to an IRA. This really is a format, or overall structure for your investments. You can hold just about any type of investment within your IRA, such as stocks or mutual funds. And you can trade any stock or mutual fund, so your choices are not limited like a 401k. There are limits, I believe that the current maximum you can invest into an IRA account is $4,000 per year. It sounds like you can invest much more than than, which is excellent. In this case you would invest the maximum into the IRA, and the rest in a standard individual account.
  You set up an IRA just like a standard trading account, perhaps at a discount brokerage firm such as www.Scottrade.com or www.foliofn.com, instead you simply select the IRA or ROTH IRA option when setting it up. The book "Investing for Dummies" does a great job of outlining 401k's, Roth IRA's, and IRA's, including a dexription of the tax benefits of each. Basically the goal is to allow your investments to grow un taxed, until you reach retirement age and begin using the funds. As you withdraw, you would be responsible for paying income tax on what you use each year. However, if you are in your mid 40's, the retirement accounts would have the opportunity to grow for 20 or more years untaxed. This make truly an immense difference.  You could invest in bonds as well through an IRA.
   The ultimate answer on what you should hold in the IRA (or 401k) really comes down to preference and the level of risk you are willing to assume. It sounds like you are more interested in stability and relatively low risk. Certificates of Deposit (CD's) and government bonds are very low risk, but also yield low returns. The highest yield CD's currently offer about 5% annual return (see www.NetBank.com for some very good rates on CD's).
   A mutual fund portfolio can double or triple that rate of return. Over 20 years, this makes a huge differences. But there is risk in the short term, you can always have a bad year. However, over 100 years of history shows that market always comes back, so the risk is really only short term in nature. With a 20 year time horizon, as long as you are the type to not worry excessively over short term fluctuations, the risk is minimal.
   The ultimate answer is a combination of very safe and slightly more agressive investments. Perhaps you should consider have a larger portion of your investments in mutual funds initially, and as you near retirement age put more into safer investments. This is a typical, proven strategy as you would not want to have a few bad years right when you plan to retire. But for the next 10 years, there is plenty of time.
   You could of course spend a great deal of time trying to select what mutual funds you want to invest in, if you decide to go this route. There is an easier way. I would look into index funds. These are mutual funds that copy a major market index, the S&P500 is perhaps the most stable and appropriate for this. For example, Vanguards fund with the ticker symbol VFINX tracks the S&P500. The fund will never do better or worse than the index, it will esssentially always match performance. You can of course do a great deal of research if you are interestd in beating average market performance, but it takes a great deal of time to do correctly. For most, average market performance is great, and you could use the rough number of 10% to 12% annualized return for such a fund.
   Below is an interesting link to an investment calculator. Enter in how much you plan to contribute monthly or yearly, and the percentage return. For example, enter 5% for the next 20 years for bonds and CD's, and see how much you would have at retirement. Then enter 12% with everything else the same, and see where you are at. Big difference! You can also see the difference between investing $1,500 a month and say $1,700 a month. Things like this really add up over time. For example, $1,500 a month at 12% average return would result in about 1.5 million after 20 years. If you change that to 5% return, the amount after 20 years would be about $600,000.

http://www.ici.org/cgi-bin/calcs/SAV14.cgi/investment_company_institute

   The ultimate answer does not need to be just one or the other. Perhaps a majority goes towards mutual funds now, slowly decreasing that type of investment until by the time you retire you are almost entirely in CD's and bonds.

I hope that this helps gets you started in thinking about how to plan and control your retirement fund. www.morningstar.com is perhaps the best known and respected source for mutual fund data (always invest in mutiple mutual funds if possible). www.motleyfool.com is an interesting community full of chat rooms and various articles on just about all types of investing. finance.yahoo.com is a good free source of data on mutual funds and stocks.
Please do not hesitate to follow up with me if I can be of any further service, and good luck! It will take focus and discipline to invest every month at first, but as you will see from the calculator, it is worth it!

Sincerely,
Paul Henneman
President
ValuEngine Inc
www.ValuEngine.com