Two Degrees of Freedom

Let’s face it. Your life is beyond your control. Way beyond. You’re buffeted about by people, institutions, and mindless powerful forces that seem to conspire to make you jump this way and that, when all you want to do is just amble in one direction for a while.

It’s certainly like that in retirement planning. When you think about it, it turns out you have just two degrees of freedom—two main tools at your disposal to affect your retirement planning: (1) where you draw the line between spending and saving; and (2) how you invest your retirement funds. Two big dials to turn, and that’s it.

The rest is outside your control: How much will your employer help with your retirement? Not up to you. Will the stock market go up or down? Not within your control. Will your income tax rates go up or down? You get no say in that. Will your roof spring an expensive leak? That’s up to the gods.

Certainly, you have other small tools that can enhance your economic well-being. For example, you can carefully titrate how much you distribute from your IRA each year to minimize the long-term tax cost. Or you can wisely decide between a traditional or a Roth IRA contribution. Or you can cleverly select which of your savings buckets should house your stocks and which should house your bonds. Making smart decisions will help—and certainly should be done. But the benefit to be gleaned from them is relatively small compared to the two big enchiladas: where you set your savings/spending dial, and where you set your investment dial.

You adjust your spending/saving dial during your working years by determining how much you will contribute to your retirement savings…which of course leaves you with less to spend on your standard of living. And you adjust the same dial during your retirement years by determining how much you will withdraw from savings, which, when added to your other available resources, like Social Security, determines your lifestyle.

You adjust your investment dial mainly by determining what percentage of your assets will be in stocks and what percentage will be in fixed income investments. For the most part, that’s it. Oh, you can certainly fine-tune the dial by carefully selecting among various subcategories of investments—U.S. stocks vs. international stocks; treasury bonds vs. corporate bonds; or index funds vs. a professionally managed portfolio; Microsoft vs. General Electric. But the big decision is reflected in how far up or down the equity/fixed income scale you’ve tuned the dial.

How do you set these dials? That requires a plan. And that’s a subject for another post.

Meanwhile, I wonder what you think. What are the big decisions within your control that affect your retirement standard of living?