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Post #4 – Retirement Savings and the Cost of Waiting

Although asset returns are certainly important to reaching your financial goals, your level of savings will be the single largest determinant of how much and how fast you accumulate wealth. And in the early years your savings rate has the biggest impact because your savings have more time to compound to reach your retirement asset goal. Most people have heard of the “The Law of Compound Interest.” Albert Einstein called this law the 8^th wonder of the world. In this blog I present a simple example of the impact of a person’s savings rate over a 40-year period. This example will illustrate very well the law of compound interest and the cost of waiting to start saving for retirement.

The Cost of Waiting

The nearby table shows, at different ages, what the monthly savings rate must be for someone, starting with a zero retirement account balance, to reach $1 million at age 65. The table calculations assume 8% annual interest which represents a reasonable long term investment rate of return for a portfolio consisting of 60% equities and 40% fixed income. The table also shows, for each age, the portion of the $1 million that is attributable to actual dollars saved and the accumulated interest amount.

Cost of Waiting Table

Notice in the table that with only 10 years before retirement at age 55, approximately two-thirds of the $1 million accumulated retirement savings is from earned income contributions and about one-third is from accumulated interest. However, if you start your retirement savings plan at age 25, the earned income contributions are only about 14% of the $1 million balance and about 86% is from compounded interest payments. After a certain number of years, your money is now working for you instead of the reverse. Most important, the table shows that the longer you wait to start saving for retirement, the more you must save per month to reach a specific savings goal. I know that $1 million in 40 years does not have the same purchasing power as $1 million in 10 years, but the table does illustrate the importance of starting your savings plan as early as possible. So ask yourself, would you rather save $286 per month earlier or save $5,466 per month later? Even though your income will undoubtedly be higher later in your life, remember the investment return rate assumed here is 8% per year which is significantly higher than most people’s income will increase every year. This means that the future $5,466 per month will represent a much larger proportion of your income than $286 per month even after allowing for wage increases over time.

There are two other reasons why starting your retirement savings plan early is important; employment risk and market risk. Trying to predict events far in the future is very difficult and is subject to great uncertainty. Employment is certainly one area where this is true. Today I am seeing unemployed people, especially people in their 50s and 60s, having a difficult time finding comparable paying work. You may love your job and plan to work until you are 75 years old, but in today’s world, working until you are 75 may not be your choice. Read this article on taking social security early. Several of these people intended to work longer but experienced an unanticipated job loss. Don’t think it cannot happen to you. It is better to start saving early just in case the job market deals you an unexpected blow in the years just before retirement.

Future market returns is another uncertainty. The previous table illustrating the law of compounding interest assumes a consistent rate of return year in and year out. In real life this does not happen as the decade from 2000 to 2010 demonstrated. Read this New York Times article closely; it discusses the impact of market risk in the last 10 years before retirement. The possibility of low (or negative) market returns in the last decade before retirement underscores even more why saving early is important. If you can get close enough to your nest egg goal before you get to your last few years before retirement, you can afford to maintain a more conservative equity allocation to protect yourself from a severe bear market just before retirement. This is one of several steps I took to keep my retirement funds intact during the recent financial crisis. Understanding the impact of your equity allocation is one of the most important concepts in long term investing. I will cover it in a future blog.

The theme of the last couple blogs is to save early and often. If you commit yourself early on to a retirement savings plan and maintain the plan throughout your working life, I am certain you will look back on that choice as one of the best decisions of your life. I know it was for me. For those of you who really enjoy your occupation and cannot imagine doing anything else, I envy you. I had a successful 30-year career as a financial analyst, but I definitely was not in love with my job. In fact at times it was downright dull. In the last 5 years of my working life (age 50 to 55), as I sat through numerous bureaucratic meetings that seemed to drone on endlessly, I cannot tell you the number of times I came out of those meetings thinking to myself, ‘Man, am I glad I saved my money.’ If you don’t love your job and have not saved adequately for retirement, I can assure you, you will wish you had started saving early and often.

How much should one save to be on track for retirement? In my next blog post I will show how to calculate a rough estimate of what your savings goal and savings rate should be.

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