Summary
Transitioning into retirement is one of the most significant moments in life that many people will ever have. Having a nice retirement is attainable, but getting there is a very involved process that requires years of careful planning and consistent effort (Safari et al., 2021). This is true from both a personal and a financial point of view. Even after reaching it, retirement planning is a continuing task that follows a person well into their senior years.
Impacts of Monetary and Fiscal Policy
To stimulate the economy and maintain price stability, a country’s central bank implements monetary policy, which includes tools like interest rate adjustments and reserve requirements for banks. The Federal Reserve Bank in the United States has a dual duty to pursue a monetary policy to maximize employment and control inflation (Chugunov et al., 2021). In contrast, the fiscal policy establishes how tax revenue is collected and how federal funds are allocated. Governments typically raise taxes and reduce expenditures to cool down an overheating economy but cut taxes and increase spending to stimulate it.
Throughout the year, the Federal Reserve’s Open Market Committee convenes eight times to discuss potential monetary policy shifts. In times of crisis, such as the Great Recession of 2007–2009 or the SARS and COV-related influenza pandemics of the 2010s, the Federal Reserve has been known to take action (Afonso et al., 2019). From a different angle, individual retirement account (IRA) planning involves putting money away into savings and investments to provide an income stream during retirement.
Changes in interest rates due to shifts in monetary policy similarly impact IRAs in both savings and investment accounts. Higher interest rates increase the allure of long-term investments like savings accounts and bonds. Stocks become more alluring as interest rates decline. For this reason, interest rates are something everyone, but especially those who are getting close to or already in retirement, should keep a close eye on.
To help save for retirement, a 401(k) allows workers to set aside a percentage of their pay in a separate account. Adjustments to interest rates due to monetary policy can also impact an individual’s 401(k) savings (Horneff et al., 2020). Increases in interest rates are bad news for bond mutual funds held in a 401(k) since they tend to see their share price and net asset value fall as interest rates climb. Conversely, their revenue will likely increase when these funds acquire additional investments paying higher rates.
Tax rates for future generations are often affected by current fiscal policy. If the government continues to spend money it does not have, the deficit will grow, and taxes will have to go up to cover the interest. Conversely, tax cuts become necessary when the government has a surplus.
Although taxation is necessary for any nation’s residents, those who contribute to a regular IRA or 401(k) plan are exempt from paying ordinary income taxes on the money they put away for retirement (Horneff et al., 2020). Instead, they will be subject to income tax on the funds at withdrawal time. That way, they save money on taxes in the year they contribute.
Impacts of Personal Risk Tolerances on the Type of Assets Included
Investment portfolios and comprehensive financial plans, such as retirement, should be tailored to the investor’s risk tolerance. Risk tolerance measures one’s willingness and capacity to take calculated risks by investing capital (Harahap et al., 2022). In general, investors in their retirement years prefer lower risk. Younger investors can typically take on more risk because they have more time. It is not an immutable law, though, that a person’s risk tolerance level needs to be assessed individually.
Those who are putting money down for a long-term purpose like retirement tend to be more comfortable taking risks as the time until that purpose becomes closer in the distance. This is because investment returns are usually favorable in the long run but highly volatile and complex to anticipate in the near run. (Harahap et al., 2022) Long-term savers know they have time to wait until their goal is reached if the market experiences a general correction or bear market.
Younger investors are more willing to take risks than their more senior counterparts. Those young at heart have many years ahead of them to work, save, and invest, but those nearing retirement may need to draw from their savings to cover basic living costs (Antwi & Naanwaab, 2022). Therefore, younger investors are better able to weather severe portfolio fluctuations. Retirement planning is crucial for older investors who are vulnerable to the devastating effects of market downturns.
Although a negative correlation exists between advancing years and a willingness to take risks, this is not always true. At times, retirees can cease working securely, knowing they would receive an adequate income from their pension, Social Security, and personal assets (Antwi & Naanwaab, 2022). Some people can handle more uncertainty in their financial investments. Therefore, this element also substantially impacts the asset allocation for retirement plans.
More risk-averse investors tend to favor a portfolio heavier in liquid assets, including cash, money market funds, certificates of deposit, and some fixed-income instruments, as well as real estate (see Appendix A). On the other hand, investors with a more moderate outlook prefer an equitable split between risky and safe assets. One possible asset allocation for an individual with a moderate risk tolerance might be 50% common equities, 40% fixed-income securities, and 10% cash (Harahap et al., 2022).
Finally, those willing and able to take on greater levels of risk tend to have more holdings of equities and other volatile assets, such as cryptocurrencies and NFTs, in their portfolios (see Appendix A). Indeed, these investors are typically younger than the average, but that is only sometimes the case. This suggests that one’s comfort level with risk should be considered while deciding on a retirement plan’s asset allocation.
Types of Risk Tolerance
Impact of Relationship between Risk and Return
The fundamental relationship between risk and return is a direct one. In general, the higher the loss potential of an investment, the higher the return it could produce. A similar logic holds for investment returns; the lower the risk, the lower the potential return. Those with a high tolerance for risk are more likely to put away a sizeable sum each year for retirement in the hopes of reaping the rewards of a high-risk investment strategy (Damodaran, 2020).
Furthermore, these individuals are typically willing to invest in retirement plans with varying degrees of risk and return. The opposite is true for people with a low-risk tolerance, who are more likely to put more of their retirement savings into low-risk investments that yield lower returns. Most of these people ignore retirement plans with a higher potential for risk and reward.
Factors Considered
The current and target retirement age lays the groundwork for a successful retirement plan. The longer individuals have until retirement, the more volatility their portfolio can withstand. If they are young and have at least 30 years until retirement, they can afford to have most of their money in riskier investments like stocks (Brüggen et al., 2019).
Stocks may be volatile, but they have routinely beaten out other investments like bonds over the long term. The key word here is “long,” which indicates at least ten years. However, as one ages, it becomes increasingly important to prioritize income and capital preservation in one’s investment strategy. This entails placing a significant portion of one’s wealth in safer securities, such as bonds. This is because bonds will not generate the same returns as stocks but will be less volatile and produce a steady income to cover one’s essential expenses.
The retiree’s marital or single status, which has ramifications for the retirement assets they can amass, should also be considered during retirement planning to ensure adequate preparation. For example, starting a family is essential to many people, yet it might severely compromise their financial security (Brüggen et al., 2019). Hence, an individual’s plan for retirement should take into account the desired number of members in their family.
Depending on one’s family situation, a retirement plan may need to be divided into several parts. Take the hypothetical case of parents who want to retire in two years, fund their child’s college education until they reach age 18, and then relocate to Florida (Guido et al., 2020). Looking at it from the perspective of putting together a pension, the investment strategy could be divided into three time periods: the two years until retirement (during which contributions are still made to the plan), the time spent saving for and paying for higher education, and the time spent in Florida (regular withdrawals to cover living expenses). Thus, the ideal allocation approach for a multi-stage retirement plan should consider participants’ time horizons and liquidity demands in retirement.
People are typically advised to select a retirement plan that includes medical coverage, even though retirement dramatically improves general health due to reduced stress from work. Retirement has been found to have no noticeable impact in terms of physical health, according to the research (Brüggen et al., 2019). However, it has a highly beneficial effect on psychological well-being. Due to this, a plan that considers retirees’ health is essential.
On the other hand, the average number of years a person can expect to live is known as their life expectancy. Estimating how long a person will live is crucial for making retirement preparations. More retirement savings are warranted if one anticipates outliving the norm regarding lifespan.
When an individual retires and either reduces their work hours or stops working altogether, the Social Security Retirement benefit will provide them with a monthly check to help them make ends meet. The monthly cost of living increases with age, and more than Social Security may be needed to cover it all (Safari et al., 2021). When an employer offers their workers a pension plan, they promise to put money aside regularly so that they can make payments to their workers once they reach retirement age. Reductions in retirement benefits like Social Security and pensions significantly impact retirement savings vehicles like IRAs and 401(k) s.
Time Value of Money
The time value of money (TVM) refers to the idea that a sum today is worth more than the same sum at a future date because of the interest that could be earned on the money. One of the most fundamental concepts in finance is the time value of money. Having a certain amount of cash on hand is preferable to receiving that same amount of cash at some future date (Joshi, 2019). Another name for the time value of money is the discounted value at the present moment.
Due to compound interest, investors would rather have a lump sum now than the same amount in the future. For instance, investors’ money in a savings account will accumulate interest over time. The interest accrues and is added to the principal over time. The value of money decreases over time if it is not invested. A person who puts $1,000 in a mattress and forgets about it for three years will lose $300 in interest that money could have earned had it been invested instead (Joshi, 2019). By the time they retrieve it, it will be worth even less than before due to inflation.
Another scenario is whether a person can receive $10,000 now or $10,000 in two years. Even though both $10,000 bills have the same face value, the $10,000 bill has more value and utility today than it will in two years due to the opportunity costs of waiting. A late payment represents a lost opportunity (Joshi, 2019).
This suggests that the time value of money is inversely related to inflation. Inflation is defined as the general rise in prices across the board. Consequently, as prices rise, the purchasing power of a single dollar decreases, limiting the buyer’s options relative to those available before the price increase.
Using the time value of money concept can help with investing decisions. Take the hypothetical situation where an investor must decide between two projects, A and B. Project A offers a $1 million cash pay-out in year one, while Project B offers the same amount in year five (Joshi, 2019). Distributions are not uniform in present value; the $1 million pay-out received after one year is preferable to the $1 million pay-out received after five years.
Different Types of Allocations Used for Retirement Assets
Diversifying the holdings in retirement savings accounts over various asset types, such as stocks, bonds, and cash, is called asset allocation. Age is a factor that should be considered in asset allocation management since as people get older, their comfort level with taking risks with their money declines (Alserda et al., 2019). As the time for retirement draws closer, a person’s ability to remain resilient in the face of fluctuations in the stock market considerably decreases.
Market corrections are stressful and costly, especially when the investment horizon is short. An emotional strain develops when a person anticipates having to make immediate purchases despite having less available cash than anticipated. A person could be scared off and decide to sell (Alserda et al., 2019). Furthermore, from a financial perspective, selling stocks at the bottom of the market locks in the losses and exposes the seller to the danger of missing the stocks’ future comeback. People can better avoid these pitfalls when they adjust their allocation based on age.
References
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