Investing for the future is serious business, but it can also be fun! We developed FP101 as a tool to help our friends and family members understand the basic principles of investment and retirement planning. The applet allows you to quickly investigate a variety of investment strategies and their implications for your retirement. It will help you answer the all-important question "How long can I afford to live before the money runs out?"

GETTING STARTED

From the point of view of investment and retirement planning, life only has two seasons: fall and winter. During the fall, all of the thrifty, hard-working squirrels gather and store as many nuts as possible. When winter comes, it's time to feast, but once the nuts are gone, there's nothing left to eat. The trick is to store enough nuts and to eat them slowly enough to survive until the spring.

The first thing to plan is the nut-collecting phase of your life. In the green area labeled "PRE-RETIREMENT INVESTMENT PLAN," enter

• your current age,
• your current retirement assets, and
• your anticipated average annual rate of return on your pre-retirement investments.

WHAT LONG-TERM INVESTMENT VEHICLES ARE AVAILABLE
AND WHAT ARE THEIR TYPICAL RATES OF RETURN?

In general, there is a trade-off between the rate of return you can expect from an investment and the amount of risk you are willing to accept. The riskier the investment, the higher the potential return. The following table shows the major investment types and typical annual rates of return.

TABLE 1 - COMMON INVESTMENT TYPES
 

Investment Type	Typical Rate of Return	Comments
Underside of Mattress	0%	Lowest return, lowest risk (unless of course your house burns down or is burgled).
Passbook Savings Account	2.0%	Rate of return is less than the rate of inflation, so the value of your assets decreases steadily, but it's safe.
Money Market Account	4.5%	Low risk with a very modest return. Good for use as an emergency fund because your assets are safe and readily accessible.
Certificates of Deposit	5.5 - 6%	Slightly higher return than a Money Market account, but the assets may not be touched until the CD matures without incurring a penalty.
Bonds	7.5%	Traditionally viewed as a low-risk, relatively high yield investment. However, a well-diversified portfolio of stocks is actually less risky than bonds over long periods and pays higher returns.
Stocks	10% (historical average)	According to economist Jeremy Siegel, the average annual growth rate over the past 200 years for publicly-traded stocks of U.S. companies is 10%.
Stock Mutual Funds	10 - 15%	Stock Mutual funds are managed portfolios of stocks. The market place offers a wide choice of funds tailored to a variety of investment strategies and risk tolerances.

HOW DO I ACCOUNT FOR FUTURE RETIREMENT PLAN CONTRIBUTIONS?

The best way to invest is like the best way to win a marathon - establish a comfortable, steady pace as early as possible and don't stop until you reach the finish line. The best savings vehicle currently available to most Americans is their company's 401K plan. These plans allow investors to contribute a fixed amount of money to an investment account every month through payroll deductions. There are several advantages to 401K plans:

• contributions are tax deductible (the amount contributed to the plan is deducted from your taxable income, thereby reducing your annual tax burden)
• the money grows tax-deferred (no taxes are levied until after you start withdrawing it in retirement), and
• most employers make "matching" contributions of up to 5% of an employee's annual salary.

PLANNING YOUR RETIREMENT

The next thing to plan is the nut-eating phase of your life. In the blue area labeled "POST-RETIREMENT INVESTMENT PLAN," enter

• your target retirement age,
• the annual income you'll need to withdraw from your retirement account, and
• your anticipated average annual rate of return on your retirement investments.

WHAT ABOUT INFLATION?

Inflation is to retirement assets what mould is to nuts, an unseen and unstoppable scourge which continually eats away at one's assets. The final step in creating an investment/retirement scenario is to estimate the rate of inflation. Over the past 200 years, inflation has averaged around 3% per year. However, most financial planners recommend using an annual inflation rate of 4% in estimating retirement asset growth. This conservative approach ensures that you won't underestimate the negative impact of inflation and end up short in retirement. By using 4%, you have a good chance of being pleasantly surprised when you open up your nut sack on December 1st.

FP101 also allows you to see how inflation erodes buying power. To study the effects of inflation, use the following settings:

• set the current age and retirement age sliders to zero
• set the current assets slider to its maximum value, $1,000,000
• set the pre-retirement and post-retirement investment return rates to zero
• set the retirement income to zero
• set all of the monthly investment contributions to zero
• set the inflation rate slider to the desired annual rate of inflation
• click on the "draw" button and watch the asset value decline steadily.

HOW DO I MAKE PLOTS?

When all of the pre-retirement, post-retirement, and inflation information has been entered using the sliders, simply press the "Draw" button to see how your assets will grow. You can continue adding new scenarios to a single graph and use different colors to distinguish the different plans. To change the drawing color, simply click the left mouse button on the desired color at the top right hand side of the screen. To clear the graphing area, click on the "Clear" button.

WHAT ADDITIONAL INFORMATION DOES FP101 PROVIDE?

To find the monetary value of any point on a graph, place the mouse cursor on the point of interest and press the left mouse button. The account value and the age at which it occurs will be displayed in the yellow area to the right of the graph. Two other useful pieces of information are provided in this area:

• the maximum value of your retirement account and
• the total amount you contributed to the account via monthly contributions prior to retirement.

WHAT OTHER KINDS OF QUESTIONS CAN FP101 ANSWER?

FP101 was designed primarily to help you predict how big your retirement nest egg will be and how long it will last given your desired level of post-retirement income. But it can also be used to answer questions such as these.

• Suppose you were to put $100 a month into an investment account for your child, starting at birth and continuing until the child reaches the age of 67. The total amount invested would be $80,400, but how much would the account be worth when your child retires? Assume an average annual growth rate of 10% and average annual inflation of 4%.
• Alice is a financially savvy young woman who starts investing aggressively as soon as she graduates from college. From age 21 to age 31 she invests $300 a month in a mutual fund with an average annual return of 10%. At age 30 she becomes a Buddhist, disavows all interest in money, and never saves another penny until she retires at age 65. How much is Alice's retirement account worth (assume an average annual inflation rate of 3%)?
• Bob is a guy who likes to party. Throughout his 20s he spends all of his money on beer and pizza. At 31 he meets Cathy, settles down, and starts investing $300 a month in a mutual fund recommended by his friend Alice (10% annual return). He keeps contributing to this account until he retires at 65. How much is Bob's retirement account worth (assume an average annual inflation rate of 3%)?

WHAT LONG-TERM INVESTMENT STRATEGY SHOULD I ADOPT?

We recommend the following general approach to retirement planning.

1. Start investing immediately - the earlier you start, the earlier (and wealthier!) you can retire because of the extraordinary way that time affects investment growth.
2. If your employer offers a 401K plan, enroll as soon as possible and contribute enough to receive the maximum amount of matching funds your employer is willing to contribute.
3. If your time to retirement is fairly long (i.e. 5 years or more), you should strongly consider investing in a well-diversified portfolio of growth-oriented mutual funds. Smart squirrels hide small caches of nuts in many different hiding places. If one cache goes mouldy or is eaten by another squirrel, no problem. The same principle, known as "diversification," applies to investing. Diversification helps you reduce risk by spreading your assets out over a variety of investment vehicles. A well-diversified portfolio includes small, medium, and large cap stocks, plus stocks of foreign companies and other investment instruments such as bonds.
4. Any additional retirement assets should be invested in vehicles which offer tax advantages, such as Traditional or Roth IRAs.
5. Follow a "buy and hold" strategy. Do your homework up front to choose well-managed funds with a good track record, then sit back and relax. When stocks are bought and sold, you have to pay service charges and brokers' commissions. These costs can seriously erode your earnings.
6. If you need advice on selecting and purchasing funds, get help from a well-established brokerage firm or a Certified Financial Planner. In many cases, initial consultations are free, and if not, you will be charged a small consulting fee. If the advice you get helps you establish a sound investment strategy, it'll be worth every penny. Another way to learn more about investing is to take a class or attend a financial planning seminar. Sometimes companies provide these kinds of opportunities to employees free of charge.

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