Chapter 4: Investing for Retirement

Many workers today are faced with decisions about how to invest for retirement, as companies offer them more choices and discretion in managing their pension funds. Because workers are often unfamiliar with these kinds of decisions, they frequently opt for safety -- investing in assets such as U.S government bonds that virtually guarantee that none of their money will be lost.

However, safety has its cost. Investments typically offer a tradeoff between safety and rate of return. Investments that are safer typically pay a lower rate of return than riskier investments. In choosing their retirement investments, workers opting for safety might be unknowingly choosing a much lower standard of living in retirement than they would otherwise enjoy. Owing to the effects of compounding, small differences in the rate of return on different investments can make major differences in the value of a retirement savings fund over the work life of an employee.

Towers Perrin, a management consulting firm with a branch office in Valhalla, New York, offers such a retirement savings plan to its employees. The board of directors was concerned that employees had chosen to invest approximately 50 per cent of their profit-sharing funds in fixed-income, low return investments. It was suspected that some employees made their choices without a full understanding of the investment alternatives and risk-return relationships associated with them. As a result, Towers Perrin set up a task force to develop options and explain them to the employees. Five different investment portfolios, embodying different combinations of risk and return were developed.

The most conservative portfolio, called Mix A, has 80% of its funds invested in conservative securities such as bonds and fixed-income investments. This portfolio has a very small chance of losing money in any given year, but it is expected to return only 6.6% per year on average in the future. At the other end of the spectrum is Mix E with a high proportion of small-company and international stocks, which are much riskier in the short run. In any given year, this portfolio is much more likely to drop in value, but it is also expected to average 11.0% annually over the long term. Mixes B, C and D represent intermediate positions between these extremes.

You might think that the Mix A portfolio would provide about 60% (6.6%/11.0%) of the income of Mix E over the years. But, owing to the effects of compounding, the difference is significantly greater than this. The graph and table show the value of $1000 invested in each of the five portfolios, after various amounts of time.

After they were educated about the tradeoff between risk and return and the impact of compounding, only 5% of active Towers Perrin employees chose to invest 100% of their money in fixed-income investments. This contrasts with 24% before the education program.

For more information on investing for retirement, see www.quicken.excite.com/retirement

What Would You Do?

1. Use a graphing utility and the formula
   
   
   
   with n=1 to reproduce the table and the graphs. In this formula, n is the number of compounding periods per year, P is the amount deposited, t is time in years and r is the interest rate in decimal form.
2. Divide two consecutive entries from the table for Mix C. What is the significance of the quotient? Repeat this calculation for other consecutive entries from the other mixes.
3. Many people put off saving for retirement until a high interest rate comes along or until they feel financially able to put aside a larger sum of money. Compare the following options using the portfolio chart. Which is better and why? Make a generalization on retirement savings strategy based on your findings.
   
   a. Putting aside $2000 (lump sum) at 6.6% 30 years before retirement.
   
   b. Putting aside $3000 (lump sum) at 7.8% 20 years before retirement.
   
   c. Putting aside $5000 (lump sum) at 10.2% 10 years before retirement.