Saving for retirement is supposed to be pretty straightforward. We budget our money, set aside some for investment purposes, and watch it compound for decades. Eventually we retire on a beach somewhere and drink mimosas till sunset.
Unfortunately, real life rarely provides a straight and narrow pathway to the retirement finish line. Obstacles and sharp turns are constantly thrown in our way, potentially derailing our saving and investing efforts and pushing our retirement dreams out of reach.
Yet according to a new study released by Financial Finesse earlier this week, Americans' state of retirement preparedness really depends on what generation they belong to.
How prepared are you to retire?
Financial Finesse's study is based on its proprietary Wellness Score, which it defines as "a state of financial wellbeing where employees have minimal financial stress, a strong financial foundation, and a plan in place to achieve key financial goals." After analyzing the Wellness Scores, which range from 0 to 10, of about 35,700 people between Jan. 1, 2014, and Dec. 31, 2015, Financial Finesse's results showed a distinct generational trend.
Baby boomers, defined as people aged 55 and up, were the strongest generation in terms of financial wellness, with a score of 5.7. Nearly four out of five baby boomers had basic investment knowledge, and half had run a retirement calculator to determine how much money they'd need in retirement. Of course, this doesn't mean all boomers are necessarily prepared to retire, as many are dealing with insufficient savings and high debt levels. But in terms of financial wellness, the boomer generation is the king of the hill.
On the other end of the spectrum are millennials, which are defined as being under the age of 30. According to the study, millennials have a Wellness Score of just 4.4. Any score between a 3.0 and a 4.9 demonstrates that "employees may be sabotaging their own goals through poor personal financial skills and are in need of more basic information."
Millennials have some work to do
Financial Finesse's data uncovered a lot of terrifying data points for millennials.
- Just 59% understand the basics of investing (down 4% from last year).
- Only 32% know their investment risk tolerance (down 5% from last year).
- Almost a quarter (24%) have 15% or more of the wealth in a single position (up 9% from last year).
- And only 23% have used a retirement calculator (up 1% from the prior year).
Financial Finesse narrowed down the struggles of millennials to two key biases -- present bias and exponential growth bias -- which tend to work hand-in-hand. The study finds that millennials generally prefer present day satisfaction over future satisfaction, which impacts the ability and desire to save for the future. Additionally, they neglect the value of compounding which builds wealth over time, thus hurting their chances of retiring on their own terms.
Yet Financial Finesse's findings also show that a minor change in financial wellness could translate into substantially more money during retirement. Employees with a Wellness Score of 4.0, 5.0, and 6.0 have average deferral rates of 6.57%, 7.38%, and 8.37% in their employer-sponsored retirement plans. With the assumption of an employee making $50,000 a year over 40 years, Financial Finesse shows that a person with a Wellness Score of 4 would have about $955,000 at retirement. However, a Wellness Score of 5 or 6 would push this figure higher by 12% ($1.07 million) or 27% ($1.22 million), respectively.
How can millennials turn things around and actually put themselves on better footing than baby boomers? Let's take a look.
Getting millennials back on track
Based on what I've seen in Financial Finesse's report, the three things millennials need to focus on are preparing for short-term unexpected costs, prioritizing long-term investments, and choosing tax-advantage smart investments that'll allow them to keep more of their money come retirement.
As noted in the study, 60% of millennials are at risk because they have an insufficient emergency fund, likely a result of their present bias and desire to kick the can further down the road when it comes to saving. The solution is pretty simple: the implementation of a monthly budget.
Millennials are a technology-driven generation, and the tools available today for those under age 30 simply weren't there when boomers were their age. Most budgeting software can help millennials understand their income and cash outflow, as well as handle the "rigors" of adding and subtracting, with a few keystrokes. Although cash flow management tends to be one of the stronger suits of millennials in Financial Finesse's study, I'd opine this is based more on luck than purpose since many are lacking a sufficient emergency fund. The importance of a budget cannot be overstated, as it'll allow millennials to quickly build up their emergency fund and potentially pay down debts, so they can do what matters most: Invest for the long term.
Secondly, millennials needs to improve their basic investing knowledge, which is something we at The Motley Fool pride ourselves on. Whether it's understanding the basics of investing or the finer points of valuing stocks, chances are there's a mountain of information to be found on our website that can move the aforementioned 59% of millennials who have a good degree of basic financial knowledge to as close to 100% as possible.
Specifically, there needs to be a focus by millennials on longer-term investing and in understanding their risk tolerance. The fact that 68% didn't know their investing risk tolerance suggests that many millennials are stuck in a short-term mind-set. If we remove our short-term goggles and look at the broad-based S&P 500 over the past 66 years, we'd see an index that's undergone 35 stock market corrections of at least 10%. But we'd also seen an index that has completely erased all 35 of those aforementioned downtrends within a matter of weeks, months, or years, thus demonstrating the long-term appreciation potential of stocks. With an average annual return, including dividends, or around 7%, investing in stocks could allow millennials to double their money many times over.
Lastly, more millennials need to be taking advantage of tax-advantaged retirement tools. Don't get me wrong, I was pleased to see that 73% of millennials in 2015 were contributing to a retirement plan, and that 80% of those were capturing matching funds in an employer-sponsored plan. This is a good foundation, but it can still get much better.
Obviously, matching up to your employer contribution is almost always going to be a good move, because it's essentially free money. But a Roth IRA can be an even smarter move for millennials. According to Financial Finesse, just 36% of millennials were taking advantage of what can arguably be described as America's top retirement tool, the Roth IRA. A Roth IRA has a lower annual contribution limit than an employer-sponsored 401(k), but investment gains within a Roth IRA are free and clear of taxation as long as you make no unqualified withdraws. A 401(k) is merely tax-deferred until you begin making withdrawals. Plus, with a Roth there are no restriction on when you have to stop contributing, and no minimum distribution requirements. You're in full control of your retirement nest egg.
Time is definitely on the side of millennials, but they clearly have some work to do.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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