Retirement Savings: Practice What You Preach
I’m rapidly approaching 26 and I have yet to set up a retirement plan.
There’s a certain irony in this, since I happen to run a startup whose mission it is to make investing within reach for everyone, a big part of which is stressing the importance of financial literacy and education.
It’s probably about time I eat my own dog food.
That said, I figured I would reflect on some retirement savings tips I’ve received over the years from others and that I’ve gleaned from my own education in finance. We created a retirement savings infographic a while back based on some of this info if you’re a visual person, but I figured I’d elaborate a bit more in this post.
I believe knowledge should be shared and information fundamentally wants to be free, so in that same vein, I hope you can use these tips in your own life as you make your retirement savings plans because, frankly, many young people aren’t yet thinking that far down the road when they absolutely should be. And as the CEO of a company that wants to help people realize the benefits and importance of investing, that scares me!
Compound Interest, Risk Tolerance & Time Horizon
So, first off I have 40 years until planned retirement which gives me a lot of wiggle room for both compounding interest and applying risk to my portfolio.
If you’re not familiar with compounding interest perhaps you’ll remember the famous question: if you could have $1 million right now or a penny that doubles every day for 30 days, which would you choose? The knee-jerk answer is the cool $1 million. However, if you choose the penny, after 30 days you will have over $10 million! No investment doubles every day, unfortunately, but the principle of compounding interest is still an important part of investing for retirement and this example illustrates it nicely.
Regarding risk, if you’re willing to increase your risk tolerance, you’ll have the potential to make more money. For example, you have two friends, Johan and Nils. They both need to borrow $100. You know Johan is pretty reliable, as he’s paid you back 9 out of 10 times in the past. However, Nils is a little less reliable and has only paid you back 8 out of 10. Johan says that if you lend him the money, he will pay you back $105. Nils on the other hand is willing to pay you back $120. Where do you put your money?
If you’re willing to risk it, you’ll probably choose Nils. But if you want a secure return on your money, you’ll probably choose Johan. Something else to consider is time horizon, or the length of time of your investment. If you have more time, you can take on more risk and lend your money to Nils. But if you don’t have much time, say 1 month, it’s probably best to lend your money to Johan.
Many retirement savings accounts operate on this same principle. Oftentimes they will invest your money in riskier investments early on and reduce that risk as you approach retirement (that is, as your time horizon gets shorter).
Something else to keep in mind for non-risky investments is inflation. Stashing your money in a savings account won’t protect you against the inflation gnomes who will, in their sneaky, underhanded, gnome-ish ways, take 3% of your cash every year. You’ll need to decide on an investment vehicle that will outpace inflation if you want to come out on top.
So, back to my own retirement dilemma. Where do I start? First I’ll need to have a clear investment objective for my retirement.
4 Retirement Savings Decisions To Make
When do I want to retire?
At 65 (40 years from now).
Remember time horizon? The longer I have to invest, the riskier I can be and the more money I can potentially make.
How much money do I desire a month when I retire?
I’d prefer $7,000 / month.
This means that if I want $7,000 a month, for say 20 years, that would be a total of $1.68M, but if I invest while I’m retired and get a modest 5% return, I only need $1.02M the year I plan to retire.
How much can I realistically save?
Let’s say I start saving $500 a month until I’m 30 and then $1,000 a month from then on. My total savings would be $456,000.
Find a good number you can realistically save right now. Don’t worry, you can always increase as your earnings potential increases over time.
Where do I place my money?
Under my mattress?
This would give me $456k when I retire, which is only $2,000 a month, less than my target desired monthly income of $7,000. Also, don’t forget the inflation gnomes. These sneaky little guys will crawl under your mattress and steal 3% of your money every year, so your $456k will actually be worth less when you reach retirement.
In a high yielding savings account?
If I place my savings in a high yielding savings account I could get 2% (if I’m lucky). This would give me $675,000 when I retire and if I keep my money in that account during my retirement I could withdraw $3,600 a month, roughly half of what I want to live on.
However, like we just discussed, if your savings account is only yielding you 2% that’s not enough to outpace inflation, so you’ll actually be losing money by stashing your money in a savings account.
Or in good companies? (This is my favorite choice.)
The average return over the past 100 years on S&P 500 companies has been 10%. If I follow this bench index (which I’m actually beating at the moment in my personal portfolio) I would have $4,550,000 when I retire.
If I reduce my risk after 65, thus reducing my return to say 5%, I could withdraw $31,300 a month on my retirement savings, much higher than my target!
Saving $500/month until I’m 30 and then $1,000 thereafter doesn’t seem impossible for me. If I keep up an average return of 10% per year I should be pretty set for myself and my family’s retirement. Of course, you’ll need to think about what works for you and how much you can save. We’ve created a retirement savings plan calculator you can use to get started. Check it out. We hope it helps!
Stay tuned for my next post where I will discuss how to choose the right retirement account for you to save thousands in taxes, and show you a path to effective retirement saving.