Investment Strategies for Late-Start Retirement Saving

In last week's column, I presented seven practical steps to help late-starting investors improve their chances of achieving a sizable nest egg to help with retirement needs. In this week's installment, I'll focus on a few more specific investment strategies to help you on your way toward retirement security.

1. Max out your retirement accounts.
It may seem obvious, but saving and investing larger sums of money over time is the surest way to meet your financial goals. If your employer offers a 401(k) or 403(b) plan with decent investment options, you should try to maximize your contribution to it. The maximum contribution for 2006 is $15,000, and investors over age 50 can now contribute $5,000 per year more in "catch up" contributions. If these amounts are out of reach for you, try to contribute the amount you need to take full advantage of employer-sponsored matching programs, as this can be a great way to maximize your investment.

Though focusing on your employer-sponsored retirement account is important, particularly if your company offers a match, you should not ignore your IRA options, as they'll provide you with added flexibility. Morningstar's IRA Calculator can help you determine which IRA option you are eligible for and what your maximum contribution amount will be. It is also important to know about the differences between the traditional IRA and the Roth IRA. To find out more about these two investment choices and determine which plan is best for you, click here. Additionally, you'll want to utilize the IRA's main advantage, tax-deferred (traditional IRA) or tax-free (Roth IRA) compounding, and thus maximize your total return while minimizing your tax burden. For some great advice on which investment options are best for your IRA accounts, click here.

If you can max out your employer-sponsored retirement account and contribute the maximum amount to an IRA option, you're well on your way. But if you still have capacity to save and invest, you might want to consider opening a taxable account through one of the major fund supermarkets or just directly through the fund company itself, if that option is available. Again, as with IRAs, there are investment options that are better suited to taxable accounts.

2. Consider a more aggressive asset allocation.
In addition to taking full advantage of tax-advantaged vehicles that might be available to you, another tactic is to consider a more aggressive asset allocation. Asset allocation is the practice of dividing your portfolio between distinct asset categories (stocks, bonds, real estate, money market/cash, etc.) for the sake of diversification and risk mitigation (because the asset classes will often behave differently from each other in various economic environments). As investors move closer to their retirements, it is common to shift assets away from more volatile equity investments into generally more stable income-producing ones, like bond funds. For example, it would not be unusual for a financial planner to suggest that, if you're an investor in your mid-50s, you hold a portfolio of 60% stock funds and 40% bond funds, because you are only a decade away from retiring, and capital preservation is key.

However, if you have not adequately prepared for retirement, this asset-class mix might be too conservative to meet your eventual income needs. You may want to consider a more aggressive allocation plan.

This can be risky, but so can failing to amass a nest egg large enough to sustain yourself for the remainder of your life. If your retirement accounts are meager it may be necessary to invest more in stocks for a longer period of time. Given the risks involved, however, you should inform yourself well about asset allocation or find a good financial planner. Remember to be aware of your own capacity to handle investment volatility and risk, because if you panic and sell an investment at an inopportune time, the more aggressive allocation, in practice, actually works against you.

The range of opinions on the proper asset allocation for each stage in the life cycle is quite broad. Few things illustrate this point as well as the widely varying allocations that can be found in our target-date retirement fund categories. (These funds are for investors with specific retirement dates in mind, as they shift their asset allocation from equities to bonds over time to prepare for retirees' greater need for capital preservation and income.) For example, in the target-date 2000-2014 category, the total stock weighting for AllianceBernstein 2010 Retirement Strategy  is 66.4%, while TIAA-CREF Institutional Lifecycle 2010 (TCLEX) has a total stock weight of 47%. Neither of these allocations is "correct" in an absolute sense, but they are different enough for investors to have a choice in allocation options, and to illustrate the differences in opinion that exist on this topic.

In a highly publicized move, Vanguard chose to alter the allocation mix in several of the funds in its target-retirement lineup. For example, the firm's  Target Retirement 2025 (VTTVX) fund beefed up equity exposure from 60% to 82.5%. The company cited "lengthening life expectancies, rising health care costs, and an acceleration in the disappearance of employer-provided retirement benefits," as part of the reason for increased equity stakes, recognizing that the risk of shareholders running out of money in retirement could be guarded against through a more aggressive allocation position. This is a tactic that can be usefully used by individual investors as well, because, as the Vanguard move illustrates, the risks of a more aggressive asset allocation need to be weighed against the risk of having insufficient investments in retirement.

3. Go global.
Another approach that could aid investors seeking to maximize their retirement assets is increasing the international exposure of their portfolio. Most investors in the United States are underexposed to international equities, and the careful addition of foreign holdings can both increase returns and reduce risk through diversification. To aid an investor who's getting a late start on retirement savings, an allocation between 20% and 30% in a foreign-equity fund, depending on your retirement time horizon, would not be unreasonable, and indeed some of our mutual fund analysts believe you could go higher. As is the practice at most target-date funds, investors will often draw down international exposure over time, but we think it would be a mistake to eliminate it entirely, regardless of your age.

A good deal of research suggests (also see Burton Malkiel's A Random Walk Down Wall Street, as mentioned in my last column) that the addition of international equities to your portfolio mix can both decrease the portfolio's volatility while simultaneously increasing its return. The proper mix of international-equity exposure, of course, has been debated, but the typically cited numbers fall between 24% and 30% of stock exposure. Many would argue that the same case should be made for the fixed-income side of your portfolio, too. Holding international bonds can add useful diversification to your portfolio, and if these securities are non-dollar-denominated, it can also provide investors with international currency exposure not easily attainable elsewhere.

4. Avoid the big mistakes.
This might sound less like an investment strategy than a timeworn maxim, but if you're not financially prepared for a fast-approaching retirement, you must be particularly careful to avoid common investment mistakes. Unlike a 26 year old with an entire lifetime of earning potential ahead of him or her, the late-start retiree can ill afford a mistake or two along the road. While there are many errors we've seen investors make over the years, two are particularly pernicious: performance chasing and attempting to time the market.

Buying into a fund after it has gained high double-digit returns for three years is perhaps one of the most natural sentiments in investing, but it is also one of the most dangerous. Loading up on a single risky or "hot" investment, in other words performance chasing, can be a dangerous game to play. A good example is  Janus Olympus , which steamrolled its competition during 1998 and 1999, producing 57% and 100% returns these years, respectively, which was then followed by three years of negative 27% annualized performance from 2000 to 2002. While this fund has performed more steadily since the bear market, it illustrates well the type of investment that would be particularly bad for late-start retirees.

Hot investments like this can be particularly damaging to a portfolio due to the fact that many investors might not have jumped into this fund until late 1999, once they had noticed its impressive returns, and they might have bailed out by 2002, having lost much of their money. There are many academic studies that argue against the practice of trying to time the market; that is, to move money between the asset classes to try to capture more of the upside while avoiding the downside. Thus, performance chasing and market-timing, particularly when practiced together, can be very destructive to your success in building a retirement nest egg. Instead, persistently investing in regular amounts, in investments that you have confidence in, is a superior method over time. Investors are much better off, in the long run, by constructing a coherent portfolio that is well diversified across asset classes and internationally, and this is particularly true for those who are beginning a bit late in the game.