We’ve all heard the expression “Give a man a fish and feed him for a day. Teach a man to fish and feed him for life.” When it comes to our kids and their finances, it’s sometimes tempting to give rather than teach, because we want to help them out and we want them to be happy. We could do them a great service, though, if we took a little time to pass on the lessons we’ve learned (sometimes painfully) about how to save and handle money.
In that spirit, I’ve included an article in today’s post that is focused on helping people in their 20s and early 30s plan for retirement. It is the first installment in a three part series that I am doing for the Omaha World Herald on retirement planning for different life stages.
As you’ll see below, starting early makes a HUGE difference. If you know someone who could benefit from that advice, I’d really appreciate it if you forwarded them the article. You can also share it to twitter or facebook using the buttons below.
Thanks in advance! I’ve heard from several of you this week who needed help with one issue or another. Don’t ever hesitate to touch base if I can lend a hand.
Note: If any of the charts or other information don’t display correctly in the email version of this post, just click the post title to view it on the web.
Want a nest egg in 40 years or so? Start early. In fact, start now.
Steven Covey once said “Begin with the end in mind.” For people in their 20s, that is about the best retirement advice you will ever get. Why? Imagine your life 40 years from now. If the past is any guide, you will just be getting ready to transition out of work and into retirement.
Assuming all goes well, Future You will have a nice comfortable nest egg set aside and will be on the cusp of an exciting new phase in life. There’s just one thing. In order for Future You to have a shot at that comfortable retirement, Current You has some work to do. Thankfully, you have a lot going for you. What are the key ingredients to getting a healthy start?
Early in life, your biggest asset is time. Those extra years can make a huge difference when it comes to your investments. The chart below shows a hypothetical example of the benefits of starting early. It compares five people saving for their eventual retirement at age 65. They save identical amounts each month ($500) and earn identical rates of return (8 percent per year, compounded monthly) on their investments. The only difference is when they start. Molly starts at 20. It’s a stretch, but she makes it work. Kelly, on the other hand, spends his extra income on a steady diet of video games and Mojitos and doesn’t get around to saving until he hits 30.
How much of a difference do those 10 years make? About $1.5 million. Said another way, Molly saved $60,000 more than Kelly ($6,000 per year for 10 years), on the front end, but that extra money resulted in an extra $1.5 million on the back end. The crazy thing? She could have stopped saving at 30 and never added another dime to her account and she still would have ended up with more than Kelly. Behold, the power of compound interest.
The longer you wait, the more drastic the difference and the more you need to save to catch up. The second part of the chart below shows how much our fictional characters would need to save each month in order to end up with the same amount as Molly. Waiting until 50 to start means that Pat would need to save more than $7,500 each month to catch up. Niel would need to put away the equivalent of a new car each month. As you can see, starting early allows time and compound interest to do most of the heavy lifting.
Make it automatic
Saving for retirement takes discipline. That is especially true if you are in your 20s and won’t see the payoff for decades to come. It’s like making a car payment each month for a car that you won’t be able to drive until 2057.
Rather than relying on willpower, make your saving automatic. Have your employer take money from your paycheck each month to add to your 401(k). Set up a Roth IRA that systematically pulls money from your checking account. You can start with as little as $25 per month. After awhile you will get used to living without the money and you won’t even think about it. I believe it was Newton’s Third Law that said “For every dollar earned, there is an equal and opposite way to spend it.” Or something like that. Make it easy on yourself. Make your saving automatic.
One of the most common questions that people have when it comes to setting aside money for retirement is “How much should I be saving?” The answer, of course, depends on your specific situation. Recently, a professor by the name of Wade Pfau has done some interesting research on this topic. He calls it the “safe savings rate.”
At the risk of drastically simplifying his research, this is the question he was trying to answer: How much does a person need to save in order to safely fund retirement even after the ups and downs of the market are taken into account?
His conclusion for someone in their 20s (a.k.a. someone who can save for 40 years)? Using historical market data and assuming an allocation of 60 percent stocks and 40 percent bonds, he found that someone saving for 40 years and then living for 30 years in retirement had a 100 percent chance of replacing half of their pre-retirement income if they saved 8.77 percent per year. Increasing the savings rate to 12.27 percent, resulted in a 70 percent replacement rate.
Of course past performance is no guarantee of the future, but his research is helpful in that it gives you a specific number to shoot for. Saving 10-15 percent of your income might seem like a stretch, but you don’t need to get there overnight. Start with something small, like 1 percent per year, with the goal of increasing it each time you get a raise. Combine that with the employer match on your plan (most employers will match a certain percentage of what you put in) and you’ll be at 10% before you know it.
Asset allocation (the breakdown between stocks, bonds and other asset classes) is a critical element to investment success. In fact, research shows that it is responsible for as much as 90 percent of return. The remaining 10 percent is determined by the specific investments you buy and when you buy them.
Work with a trusted adviser or the representative assigned to your plan at work to make sure your allocation is appropriate for your situation. Then review that allocation regularly and make changes as necessary.
Don’t raid the piggy bank
The average person changes jobs 5-10 times over a lifetime. Each time you change, it’s tempting to take the money from your 401(k) rather than rolling it over to an IRA or to your new employer’s plan. This is especially true if you have things like moving expenses or if you lost your job involuntarily and need some resources to make ends meet. Do everything you can to avoid taking these premature distributions. Not only will you pay taxes and a penalty (assuming you’re younger than 59 ½), but it also means that the advantages you gained from starting early go out the window.
The biggest objection to starting early is that it’s not easy to save at the front-end of your career when your income is limited and you have so many expenses like a new work wardrobe or furnishing your house or apartment. I’ll let you in on a little secret. It doesn’t get any easier. There will always be wants and needs competing for your limited resources. The key is deciding to start, no matter the amount, and then making saving a lifelong habit.