The 10-Step Staircase to a Comfortable Retirement

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The secret to saving enough for retirement is simple. Start early and increase the amount you save over time. For many people the hardest step on the journey is that first one. Think of saving for retirement as climbing a staircase. Step One is to save enough money each year to receive the full employer match available to you under your company 401k plan. Often, this is around six percent of salary. (See also: How to Make the Most of Your 401k.)

Why is this step so important? One, it gets you in the game. Two, the employer match is free money. Depending on the generosity of your company plan, the employer match could equal anywhere from a 25 percent return on investment to a 100 percent return. Nowhere else in the investment universe do you find returns like this so easy to attain.

In order to get started, you may need to construct a budget and cut some expenses. Two of the usual suspect categories are a) “walking around money,” the kind you withdraw from an ATM or put on your debit card, and b) take-out food. Master these two categories and you will save enough to get started.

One Step a Year

Once you are saving something, plan to increase the amount you save by one percent a year. Make a pact with yourself that you will do this like clockwork every year for ten years, until you are saving 16 percent of your salary. Think of it as climbing a staircase one step at a time, one step per year. If you start saving six percent a year at the age of 30, you will reach your goal by the age of 40. By that time, in comparison with the average saver, you will be at the top of the class.

This regimen may not make you rich in retirement, but it should easily put you easily in the top 10 percent of American savers. According to the 2008 Employee Benefit Research Institute survey, Americans in their 40s with a job tenure of between 10 and 20 years have an average of $65,512 in their 401k plans.

If You Start Early, Time is on your Side

Remember: the earlier you start, the easier it gets. Dollars put away while you are in your twenties have up to 10 times the earning power of dollars saved later.

If you started saving six percent of your salary per year at the age of 25, based on a salary of $30,000, an employer match of 50% and an annual return of 8%, and you just left that arrangement on autopilot. Even without a raise throughout your life, you would amass $750,000. This is far more than the average 401k contains today. But our method combined with your growing salary may net you, believe it or not, something in the range of $2 million dollars. But if you wait until you are 40 to start saving, even if you save a much higher percentage of your income, odds are great you will never crack a million.

If you want to run a few numbers yourself, Bloomberg and CNNMoney offer online retirement calculators. Neither of these, unfortunately, allows you to model the stair-step method featured here.

Adjust Your Allocations as You Age

Consider sensible, yet aggressive, market allocations for the long haul. You do not need to restrict yourself to “investing your age” in stocks. This is an old rule that says whatever your age is, subtract it from 100, and that should be the percentage you have in stocks. That is too conservative if you are only 30 or 40 years old. According to US News, retirement savers in their 30s, invest roughly two-thirds of their portfolio in stocks. That’s too conservative. Many experts say you can put as much as 80 or 85% of your money in stocks at the age of 30. Find your comfort zone and then, as you get older, consider transferring some percentage of your holdings to your bond fund every year that stocks rise.

On the other hand, 100% in stocks is never appropriate. Studies show that a 90-10 stock-bond allocation is appreciably safer than keeping it all in stocks, while the investment return is just a fraction of a point less than an all-stock portfolio. And an 80-20 split doesn’t earn a lot less than a 90-10 split. Moreover, of course, it is less risky still.

Use Index Funds

John Bogle, the pioneering founder of Vanguard Investments, observed years ago that most people give up a good bit of their potential investment returns by chasing returns of previous winners and spending too much on investment costs.

Instead of trying to pick winners (which no one can do reliably over time), Bogle suggested the investor buy the entire market through an index fund and trade only to rebalance allocations for annual investment earnings and long-term risk adjustment. Thus, the birth of the couch potato portfolio—the amazing breakthrough designed to prevent the investors from becoming their own worst enemies.

Unfortunately, many companies do not offer index funds in their 401k plans. If this is the case, ask your company to introduce one or more. Mention Vanguard as an example. Their premier index fund is called the Vanguard Total Stock Market Index Fund. Other companies offer similar products. You will need a bond index fund, too.

Wise investors invest in international markets as well as U.S. stock funds. Often, you will see 20 to 25% of the amount invested in stocks allocated to offshore funds. There are other wrinkles as well, but you can get started with just three funds: a domestic stock index fund, an international fund, and a long-term bond index fund.

One important tip is to rebalance your portfolio at least once a year. If stocks have a good year and increase by 10 percent, your 75-25 stock-bond allocation will be knocked out of whack. It may look like a 77-23 portfolio by the end of the year. Transfer some of those earnings back to your bond fund to regain the 75-25 target allocation. This forces you to do what only the most brilliant investors do: buy low and sell high. (Other than rebalancing, resist the urge to tweak your allocations.)

Discipline helps in tough times. Even if your employer suspends the match, as many have done during the economic meltdown, maintain your Step One investment. Oh, and never borrow from your plan. Repeat: do not touch this money during your working years. You are better off taking a temporary or second job rather that raiding your nest egg. If you do, chances are very great you will never make it up. So make imminent starvation the bar for raiding the piggy bank.

Defined contribution retirement plans, or 401ks, are pretty much the only game in town when it comes to saving for retirement these days. Learning to invest wisely and sufficiently in a 401k will put you in the top echelon of individual savers. It will make you feel better about your money life. Saving for retirement is one of the Big Three economic commitments in life: retirement, house, education. So give it your best shot — one step at a time, one percentage point a year.