Let's face it: no one becomes a cop to get rich. The reality is, if you do this job ethically and leave time for family and hobbies, you might actually qualify for government assistance. Sad, but true. So, if we can't be rich working, what is the financial promise for the future? For many of us, it is a pension. Even that, though, is not a guarantee of financial security. My agency gets 50% after 20 years; some places offer more, others require a minimum age. Most pensions are similar in that after 25 or 30 years of work you'll get 60-75% of your salary for retirement.
That's not bad... but 75% of squat is still pretty near squat. Deferred compensation plans are your way to supplement your pension, and retire comfortably.
Risk vs. Return
Deferred compensation plans normally fall into two types of accounts: 401K and 457 accounts. You fund these; you select a percentage or a fixed amount to be deducted from each paycheck (tax-free, mind you) and it is deposited into your account. If you are lucky, you get a partial matching contribution from your employer. This money is then invested on your behalf in the manner you specify.
That of course, brings us to the main issue: how do you choose where to invest? It is a great question without a great answer. It's sort of like a use of force (or response to resistance as we now call it) report; what is appropriate for one person in one situation may not be appropriate for another person in a different or even similar situation.
The main issue is to look at risk vs. return. Risk, in this sense, is the likelihood that you might lose money. Return is the amount your money can earn if you place it in a certain investment or fund. In the financial world, people pay to use your money. They also pay to buy investments that have great potential, and that is how your contributions increase in value.
These two factors, risk and return, are always related. Think of a simple savings account at a bank. The deposit is insured by the federal government, so if the bank fails, you get your money back. You can also take it out of the bank whenever you want. In short, there is no risk. However, banks currently pay about 0.3% interest on a savings account. Placing your money in a savings account is almost the same as giving it to the bank free. Compare this to a US government 30-year bond. While there is no risk (or almost no risk) of default, there is risk in the value. Bonds currently pay about 4.5% interest. However, that amount is fixed for 30 years and you cannot cash in the bond early. So for the inconvenience of tying up your money, and for potentially losing money if inflation is high, you are paid a higher interest rate. A 30-year bond from a city demands an interest rate of 5.1% or so, since the likelihood of a city going "bankrupt" is slightly more than the US government (hard to believe, huh?).
This type of relationship occurs among all investments, from bonds to stocks to futures to exotic financial instruments. If someone promises high returns with no risk, it's a scam, plain and simple. Risk and return are always related.
Balancing Risk
While risk is present, you cannot be afraid of it. Without a certain level of risk your investments cannot earn decent returns. Yes, you can put all of your money into a savings account, but you won't get much richer. In fact, at today's rates, if you contributed $200 a month for 25 years, you wouldn't have much more than the $60,000 you put in. By placing your money in riskier investments, with returns that match, you could have $300,000 or more.
So how much risk do you take? That's up to you. Some people like to gamble more than others, and frankly, the stock market is a little like gambling. The key is to remember your long-term goal. Generally, young people can afford to take more risks. This may sound obvious, but there is a good financial basis for it. If a 25 year old places $10,000 of his retirement money in the stock market, he has 30 years to make up any losses. A 55 year old planning to retire in 5 years does not have time on his side.
When considering risk, look at two factors: your personal tolerance for losing money occasionally and the years you have until retirement. I can't adjust your personal side - that's up to you. But you can adjust for the time factor. If you have decades until retirement, place most of your money in the most aggressive investments you can tolerate. Some advisors say "all" of your money should go into stock-related investments. Personally, I'm not a big "all or nothing" person; I like a little stability and leave about 10-20% in balanced funds. Yes, this hurts my overall return, but it makes me feel better.
Then as you get closer to retirement, begin transitioning from aggressive to moderate investments. When you begin counting down the years, you should move to mostly income preservation and capital preservation funds. This means that at retirement, you will want nice, boring investments like money market accounts, certificates of deposits and government bonds. Why? Because you won't lose your money. No, it won't grow fast, and if you are withdrawing money, you might take out more than your funds earn. However, a sudden market downturn won't wipe out 10 years of retirement funding either.
So what do I look for?
Your deferred comp plan should have a number of investment options that span different risk levels. There are different names for them, but here are the general groupings and general risk levels. Keep in mind, this is a generic list:
- Equity Funds - These funds invest solely or primarily in stocks. Some of these may specialize in types of stock (large-cap or small-cap, for example) or in market segments (such as technology, precious metals, etc.) As the stock market, or market segment, goes, so goes the fund value. Historically, this is the best way to make money, but it is also the riskiest. Some funds have lost 20% just this year; many more are in the -5% to -10% range. People with decades until retirement should have lots of money in these types of funds.
- Balanced Funds - These funds combine some stable stocks, a few risky ones and some bond investments. These provide a good rate of return with a little less risk than pure equity funds. They still have some volatility, but not an outrageous amount. The disadvantage is that increases in the stock market are usually balanced by losses in the bond market, so the overall return is moderate. These are good for people with lower risk tolerances, or as they start to count retirement in years instead of decades.
- Income Funds - These funds try to ensure a steady stream of income, presumably in preparation for your pending retirement. They invest in lots of bonds, though not exclusively, in an effort to maintain the value of the investment and return a respectable interest rate. You will not get rich if you invest in these, but when retirement is closing in, you should already have accumulated most of your wealth. Now you don't want to lose it if the economy tanks.
- Money Market Funds - These funds actually buy government and bank obligations. They normally try to balance themselves so that a share is always worth one dollar. These are very safe investments, although not guaranteed. Their rates of return reflect the safety, as they are currently about ¼ what you could expect in a normal equity fund. When retirement is counted in months or weeks, more and more of your retirement money should be transferred into these funds.
- Retirement Target Funds - These funds are, essentially, mutual funds that buy mutual funds. They are becoming more common and are designed to take out some planning (and anxiety) on your part. With these funds, you choose an approximate retirement year. The fund then uses a fixed ratio to adjust your risk level. For example, if you plan to retire in 2025, the fund might place 70% of your money into equity funds. As you get closer to retirement, the Target Fund will automatically start moving your money from equity funds to less-risky investments. The goal would be that by 2025, most of your money would be out of equity and in income and money market funds. The exact investment plan should be in the Target Fund's prospectus.
As you track your investments, don't fret over daily or even monthly changes. Remember, you are investing for 20 or 30 years from now - not next year. What you want is a regular growth rate. If a fund is a regular dog in comparison to other funds in your plan, then consider a transfer. But don't move your money around on a weekly or monthly basis, trying to chase the best performing fund. You'll be chasing history, and you will likely miss the growth periods of the fund you enter as well as the fund you leave.
Conclusion
Retiring on a pension is a benefit of being a cop. It is a little reward for years of hard, honest work. Deferred comp plans give us a way to supplement the pension, and retire comfortably. For the deferred comp plan to help, you must take risks to enjoy better returns. These risks can be controlled, and even adjusted for personal preference. The risks can also be reduced as your retirement draws closer.
Sure, no one likes the idea of losing his retirement money on an investment. That said, investing with moderate risk is the only way to build a nest egg that will allow you to retire where you want. And the reality is, if you couldn't stand a little risk and uncertainty, you would never have become a cop.
