Retirement Basics for Young Investors

I know the first thing that will come to mind for many younger investors: "We are young, do we really need to worry about retirement yet?" The answer is an overused phrase, "it is never too early". I understand that this article will fall on many deaf ears as it is not as sexy as the new hot growth stock that can triple your investment in a year. Still, I believe that the general lack of understanding of retirement planning among the younger investing cohort more than warrants the effort.

Some areas of interest that I will be taking a look at are diversification, prudent asset and insurance planning, and the use of IRA's and employer sponsored retirement plans. While one strategy does not fit all retirees, this article will provide some basic guidelines that should apply to everyone.

There are 3 major things that every individual should have before considering investing for their future retirement. These three things are: Health Insurance, Disability Insurance, and Lack of High-Interest Debt.

• Health Insurance: Every person on this planet should have some type of health insurance. Medical costs are on the rise and will be for some time. The number one cause of bankruptcies in the United States is due to the inability to pay medical bills. This is why it is absolutely essential for individuals to obtain health insurance even before paying for retirement.
• Disability Insurance: Workers need to protect their ability to earn an income. If your income stream is cut off by injury you need a way to support yourself. For those banking on the social security system to provide a backstop, you will be surprised to learn how much of a mess it is. If you don't think disability is a realistic possibility, take a look at these statistics.
• No High-Interest Debt: This is a very simple and intuitive rule. You should not be looking to invest at all until you have paid off your high interest debt. There is no point in saving for retirement while you are paying 20% on your outstanding credit card debt.

Once you have taken care of these three areas of concern, you will be able to start planning for your future retirement

Young employees today most likely have some form of a defined contribution retirement plan. This means that you and your employer both pay in a certain amount every pay check. The employee assumes all the investment risk from the plan's portfolio. The most common of the defined contribution plans is a 401(k) plan.

401(K) Plan

A 401(k) plan by its nature is not very complicated. There are two major reasons that employees should contribute to their plan.

First, by keeping your retirement funds in this type of plan you are sheltering the funds from potential tax burdens. At present you are allowed to contribute up to $16,500 and an additional $5,500 for individuals over 50 years of age. The money that goes into the plan has not been taxed yet. The funds then proceed to grow at a tax deferred rate. Once you retire (assuming you are over 59 1/2) you can roll your 401(k) plan into an IRA and begin taking distributions. Since there were no taxes paid on this money when it went into the plan they must be paid on the way out. All the proceeds are taxed as ordinary income according to your marginal tax rate.

The second reason that you should contribute to an employer sponsored retirement plan is because it may provide a lucrative incentive -- an Employer Match. Some employers choose to reward their workers by matching a certain percentage of their contributions. This is free money and any employee when offered this match would be crazy not to take full advantage of it.

Now I want to talk about the way in which you should contribute to your 401(k) plan. If you are lucky enough to work for a company that will match your contributions then you must take advantage of them. However, after you have used up your match for the year, there really isn't a strong incentive to keep contributing to your 401(k) instead of opening an IRA or Roth IRA.

There are multiple reasons that I advocate moving additional contributions to an IRA. First of all by moving to an IRA you give yourself a much larger selection of possible investments. For many individuals this will not particularly matter as they don’t plan on having an active investing role. However, if it was my money I would want as many options as possible. You could simply purchase a low cost S&P 500 index fund that will most likely outperform any mutual fund over a 5 to 10 year time period.

The second and probably more important feature of having your money under your own control is not having to pay the fees charged to you by the fund company running your plan. These fees are often hidden as they are taken out before your overall return is given to you on your statement. By opening an IRA with a low cost fund you not only save yourself some fees but you also provide yourself with more investment options.

IRA (Traditional and Roth)

Individual retirement accounts (IRA) are a form of retirement plan that provides tax advantages for retirement savings. This is normally separated into two kinds of IRAs; Traditional and Roth. The maximum allowable contribution for 2011 is the lesser of 100% earned income or $5000. You can begin taking contributions by the time you are 59 1/2. At 70 1/2 you are required to take minimum withdrawals. The amount of each minimum withdrawal depends on your IRA account balance at the end of the previous year divided by a joint life-expectancy figure for you and your account beneficiary (even if you don't have one!) found in tables published by the IRS

• Traditional

Contributions are often tax-deductible (often simplified as "money is deposited before tax" or "contributions are made with pre-tax assets"), all transactions and earnings within the IRA have no tax impact, and withdrawals at retirement are taxed as income (except for those portions of the withdrawal corresponding to contributions that were not deducted). Depending upon the nature of the contribution, a traditional IRA may be referred to as a "deductible IRA" or a "non-deductible IRA."

• Roth

Contributions are made with after-tax assets, all transactions within the IRA have no tax impact, and withdrawals are usually tax-free. Many people choose this type of retirement vehicle to lock in the low tax rates that we have right now.

Investing Strategies for Retirement Portfolios

There are some general strategies that you want to follow when investing for retirement. One major strategy is the idea of asset allocation. You want to set your portfolio up so that at all times you have exposure to Stocks, Bonds, and Cash depending on your age and your general feelings on the market.

In your 20's you should have little or no exposure to bonds. This is because you have many years of compounding to make up for any losses that you could experience in this period. As you move into your 30's, 40's, 50's, 60,s and retirement your exposure to the bond market should rise in kind. So once you reach retirement you should have somewhere between 60 -70 percent of your portfolio in bonds.

One classic mistake that many young employees make is to buy stock in the company that they currently work for. This goes back to the idea of diversification. Imagine that you have a good portion of your net worth tied up in your company's stock. The company's business takes a downturn which lowers the stock price. The management decides to downsize and unfortunately you get laid off. Now not only do you not have a job, but your retirement portfolio has taken a significant hit as the company’s stock has fallen.

My Market Outlook

The market has been experiencing extreme amounts of volatility lately. The amount of fear in the market has hit a high as Europe's sovereign debt crisis continues to jostle us. However, the earnings for US corporations seem to still be very strong and the economic data has strengthened over the past few weeks. This leads me to believe that the chance of the country falling into a double dip recession has declined. Still, there seems to be a large amount of headway for the United States in terms of getting back to strong GDP growth rates. This is why I am of the opinion that we are in for a prolonged period of low growth.

With this outlook in mind some of my favorite sectors over the coming few years have trended towards the defensive. These include Healthcare, Utilities, Tobacco, Fast Food, Soft Drinks, and Telecoms. My favorite companies in these sectors tend to have wide international exposure and provide investors with stable dividend payments.

Healthcare: Johnson & Johnson (JNJ), Abbot Laboratories (ABT), Bristol Meyers Squib (BMY), Novartis (NVS), AstraZeneca (AZN)

Utilities: Duke Energy (DUK), Dayton Power & Light (DPL), Exeleon (EXC), Public Service Enterprise Group (PEG), Pacific Gas & Electric (PCG)

Tabacco: Altria (MO), Phillip Morris International (PM), Reynolds American (RAI), Lorillard (LO)

Fast Food: McDonald's (MCD), Yum Brands! (YUM)

Soft Drinks: Coca-Cola (KO), PepsiCo (PEP)

Telecoms: AT&T (T), Verizon (VZ), Centurylink (CTL), Vodaphone (VOD)

Conclusion

The purpose behind this article is to raise the awareness of retirement planning for the younger generation. It is important for young investors to start this process early so they take advantage of as many years of compounding growth as they can. Instead of leasing that new car that is out of your price range make an investment in your future. Retirement planning is one of the most important long-term decisions that you will make in your life. Will you choose to be vigilant or irresponsible? Young investors should do their own research and come to their own conclusions. This was written to hopefully spark some interest by providing the basic guidelines for retirement planning.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.