Here’s a big word for you from the world of behavioral finance – hyperbolic discounting. Hyperbolic discounting is a time-inconsistent model of discounting. Ok, that didn’t help much. Think of it this way – humans have a tendency to value short-term rewards over longer-term rewards, even when mathematically the rewards are worth the same. The farther away the reward, the more we tend to discount it.
How does it work? Assume someone has the choice between $20 now or $100 tomorrow. Most will wait a day and collect the $100 reward. But what if I were to offer you $20 now, or $100 a year from now? Turns out many people will opt for the $20 now, discounting the value of a larger reward because it is so far into the future. So expressed another way, hyperbolic discounting is a person’s desire for an immediate reward rather than a higher-value reward, at some point later.
Ok, let’s test your newly acquired knowledge. You have $650 left in your pockets and the new iPhone just came out. What do you value more, the new phone now, or the thousands of dollars your pocket money might grow to become by the time you retire 30 years from now?
Turns out you don’t have to be a lawyer to understand this concept, because it affects everyone the same. And that’s why law professionals, just like the rest of us living in today’s society, struggle to plan ahead and save adequately for retirement. So what can you do today to help ensure you’ll have what you need tomorrow?
So, first things first, if you are a firm owner, sole proprietor, or administrator in your practice, let’s talk about establishing a plan for your firm. Statistics have shown that people are much more likely to save for retirement if a 401(k) plan is available to them through the workplace. However, access to such plans has been a challenge when it comes to smaller employers, who typically choose not to sponsor a plan. Of all small employers – those with 10 or fewer workers – only 16.5% sponsor a retirement plan, according to an Employee Benefit Research Institute estimate. This is especially noteworthy in light of the fact that, according to the latest Statistical Report by the American Bar Foundation, 9 in 10 lawyers work for firms that have fewer than 10 attorneys. The propensity for law firms to be small means that having access to a workplace retirement plan is still a challenge today.
If you’re not already sponsoring a 401(k) plan and don’t know what to do, think about your key objectives. Do you want to minimize cost to your firm? Are you looking to attract and retain valuable employees? Or do you simply want to maximize tax advantaged benefits? Based on your key objectives, there may be several different retirement plan options that fit your needs. For example, if you are looking to minimize cost, a 401(k) or profit sharing plan might be the right fit. A safe harbor 401(k) or a cash balance plan can help to attract and retain employees. And if you are looking to maximize your tax benefits, you may want to look into a cross-tested plan or personal pension plan where the opportunity to save on a tax-deferred basis is much greater.
These are not necessarily easy questions to answer. If you find yourself struggling through the process, don’t worry. While there may not be an app for that, there are knowledgeable financial professionals who specialize in retirement plans. A qualified advisor or consultant can help you determine what’s best for you and your firm, explain how various retirement plans can deliver on those objectives you’re looking for, and even assist you in finding and evaluating suitable providers. You can even find online tools that can help orient your decision making when it comes to selecting the right retirement plan that fits your needs and the needs of your firm. Now that we’ve established a plan, let’s get back to the behavioral side of this equation. If you’ve read this far, you’re probably like most working Americans, and see your 401(k) plan as the cornerstone to your retirement savings. But if you’re not, and you believe you’ll never retire from practicing law, consider this: One in five retirees do not retire on the planned-for date due to illness or health issues. One of life’s realities is that with old age comes a variety of health concerns that may impact your ability and willingness to practice law. Law professionals are often forced into retirement due to ailments or health conditions.
The uncertainty about what your health has in store for you down the road is cause for planning. So whether you plan to retire or not, consider just a few simple tips that can help you be ready to retire with the dignity and financial security you expect and deserve.
Tip #1: Participate in your Plan
If you haven’t yet enrolled in your 401(k) plan, make it a point to do so now. People are living longer now than ever before. According to a report by the U.S. Census Bureau, the U.S. is projected to have 9 million people above the age of 90 by 2050 – this is up from 1.9 million in 2010 … and 720,000 in 1980. This means our nation’s 90-and-older population has nearly tripled over the past three decades … and is projected to quadruple over the next four decades. These longer life spans, coupled with spiraling healthcare costs, the uncertain future of Social Security, and the decline of public pensions, mean individuals are increasingly responsible for funding their own retirement.
Contributing to a 401(k) plan can put you on the right track to be able to fund your retirement years. The money you contribute is tax-deferred from both federal and state income taxes, which means you don’t pay taxes on the contributions until you withdraw the funds, typically at retirement age. Furthermore, contributions to the plan are deducted automatically from your paycheck, making the process seamless for you.
For law professionals this tip is especially important. The law profession is characterized by busy, time- consuming schedules with little time for planning outside of work. As a result, law professionals compulsively push off the decision to start saving. As inertia sets in, many people are left feeling as if their bank account was a ticking clock and too few years remain until retirement.
If you’re unsure about how to get started, take advantage of the many helpful online tools and resources available to you, such as Voya’s MyOrangeMoney (voya.com). These tools offer an easy way for you to determine how much you need to save to reach your retirement goals, and how different contribution rates will impact your retirement savings.
Tip #2: Take advantage of matching contributions
If your plan offers a company match, take advantage of it! This is a valuable benefit where your employer will match your contributions – typically capped at a percentage of your pay. For example, a company may offer a dollar-for-dollar match up to 3% of pay, or a 50% match up to 6% of pay. Find out what your employer will match and, at the very least, contribute enough to take advantage of the match.
Many law firms will offer generous matches and sometimes profit sharing plans where the employer has discretion to determine when and how much the company pays into the plan. The amount allocated to each individual account is usually based on the salary level of the employee.
Tip #3: Make catch-up contributions
If you are age 50 or older (or will be by the end of the calendar year) and your plan allows, take advantage of the “catch-up” provision. Legislation has made it easier for you to save more for your retirement with the permanence of the “catch-up” provision outlined in the Pension Protection Act of 2006. In addition to the general deferral limit of $18,000 for 2017, you can contribute an additional $6,000 for a total of $24,000. This means if you are 50 years old this year and haven’t started saving for retirement, you can contribute nearly as much as $250,000 over the next 10 years – tax-deferred – to your 401(k) plan. When you consider the potential of compound earnings, this can add up to significant savings.
Tip #4: Keep your savings working for you
Even if the plan allows you to borrow from your plan, think twice before doing so. While it may sound appealing, borrowing from your 401(k) reduces the benefit of tax-free compounding that is the key to building up savings. Although sometimes unavoidable, before you make the decision to take a loan, there a few considerations to take into account:
- You will pay interest on the loan with after-tax dollars, thereby losing the tax advantage.
- You will pay taxes a second time when you eventually withdraw the money in retirement.
- Interest on the loan is not tax-deductible, even if funds are used for a home purchase.
- Most loans must be paid back within five years, but if you leave your job, the loan must be paid back in full immediately or the amount becomes a taxable withdrawal.
Tip #5: Invest for the long term
Once you set your investment allocations, be patient. Predicting the market is not like predicting the weather. There are no high-tech gadgets or radar systems to predict the highs and lows that may lie ahead. It’s critical to remember that what is important is time in the market, not timing the market. Discipline yourself to maintain your allocation through down markets as well as up markets. Having a properly diversified portfolio will help make any market swing easier to digest. Conduct an annual review of your plan to confirm your allocations still align with your life stage and economic circumstances.
Tip #6: Consider spending time with a financial professional
According to Voya research,1 those who spend time with a financial professional are saving more than their peers who do not, with greater investment knowledge and confidence in their ability to enjoy retirement. If you have never received help from a financial professional before, this is something to consider pursuing.
Many things require planning – purchasing a new car, choosing a vacation destination, studying for the bar exam. So should retirement. As a law professional, time can be of the essence. And while the short-term benefit of working on billable hours now may seem greater than the longer-term benefits of saving for retirement, remember what you learned. The effort you put into planning your retirement today can positively impact your ability to live comfortably in retirement … even though your hyperbolic-discounting-mind is telling you otherwise.
1 Advisor Value, A Voya Retirement Research Institute® Study, 2015, www.VoyaRetirementResearchInstitute.com
Press inquiries: Christine Hotwagner
Program Operations Director ABA Retirement Funds