This is part two of a five-part series on Retirement Planning.
Part 1: Years to Retirement
Part 2: Savings Rate
Part 3: Inflation
Part 4: Social Security
Part 5: Large Asset Ownership
I vividly remember a time when I was extremely angry at my dad about having to do chores around the house, telling him that I wasn’t going to complete them and that if he had to, he could take away the allowance I was receiving.
Surprisingly, he turned to me very calmly and said, “Your allowance doesn’t have anything to do with your chores. You do chores because you need to learn how to contribute to a household. You get an allowance because we want you to learn how to manage your money.”
This lesson has always stuck with me.
Another thing my parents did, in conjunction with an allowance, was to match my contributions any time I put money towards long term savings (college and beyond).
Whenever I received my allowance, they set a default saving rate at 10% of my earnings. That means every time I received my allowance, I would put in 10%, or more, and they would match that amount, dollar for dollar. I’d kill for a 401(k) matching program like that!
By the time I went to college, I didn’t need to take out any student loans. Between minimum wage work and savings, I managed to graduate college without taking on any debt – something that I’m very thankful for.
Savings Rate Statistics
Savings rate is not as important as timing of the savings, but it is still an important consideration. Having a better understanding of how compound interest works will help you fully understand this concept of Savings Rate.
According to Statista.com, in 2018, the personal savings rate in the United States was 8.8%.
The current median household income is around $63,000. If we assume an 8.8% savings rate (works out to be $5,544, increasing with raises) for 30 years (let’s assume age 35 to 65), a 5% annual income raise, 3% inflation, 10% growth return, 4.5% retirement return, 7% transition return and a 5 year transition time, then we will only be able to afford 11 years in retirement. Meaning by the time you reach the age of 76, if you aren’t dead, you’re definitely dead broke.
Comparatively, in 1960, the savings rate was 10.4%. Given the same assumptions as above, with the higher savings rate (only 1.6% higher, $6,552 in year 1, increasing with raises), we’ll get 14 years of a comfortable retirement. Under this assumption, we’ll have 79 years before we are in deep financial trouble.
If we save 15%, we get 21 years of retirement and at 20% we get 30 years of retirement. Each one of these scenarios assumes a flat savings rate. You are giving the same percentage of your annual income to your retirement savings account.
But your savings rate doesn’t need to be consistent. You can change the rates over time as you wish, but it’s important to always remember the power of payment timing. Sure, saving more money is without a doubt better than saving less money, but saving earlier is often more powerful than saving more money, largely impart due to the power of compound interest.
A Few Examples
Assuming only a 10% interest rate (no inflation, no transition, just interest), if you made an investment of $20k every year for 30 consecutive years (a total of $600k), you’d end up with $3,321,607.
If instead, you saved $30k for the first 10 years, $20k for the second 10 years, then $10k for the third 10 years (also $600k over 30 years), your cumulative total would be $4,250,286.
If you did it in the reverse order, first saving $10k for the first 10 years, then $20k for the second 10 years, and then $30k for the third 10 years, you would end up with $2,392,928. That’s a difference of nearly $2 million dollars of accumulation with the same $600k over a 30 year period.
Payment timing has a large effect, but any amount of savings now will significantly help, and increasing savings over time is better than not saving at all.
You can see the effect of savings vs time even better by showing the difference in the amount of savings needed.
For example, if you saved $10,000 per year for the first 10 years, and nothing else for the next 20 years, you would have around $1,000,000 at the end of that 30 year period. That means you would need to save 2.5x more ($25,000) per year for the second ten years (years 11 through 20) and then nothing the last ten years, to get to the same $1,000,000 amount.
However, if you waited until the last 10 years before your retirement to save any amount, the savings rate requirement becomes extreme. If you save nothing for the first 20 years, you would need to increase your savings rate to $60,000 per year for those last 10 years to reach the same $1,000,000 goal. This works out to be 6x more in total savings than you would need if you started saving in the first 10 years and 2.4x more total savings than saving in the second ten years (years 11-20) to accumulate the same amount in total retirement savings.
The moral of the story here? The sooner, the better when it comes to your retirement savings.
Presumably, you will earn a larger income later on in your career compared to early on, making it much easier to save more later. But don’t discount the importance of early savings contributions.
By getting an early start, you can increase the amount you save while decreasing the saving rate later in your career. As another example, let’s say you currently earn $40,000 and you are saving $10,000 (a saving rate of 25%) and plan on saving $12,000 when you start to earn $60,000 in 5 years. In this case, you are saving more in dollar terms (an increase of $2,000 per year), but you end up with a lower savings rate (savings rate drops to 20%).
Keeping a high constant savings rate will be much more beneficial in the long-run compared to decreasing the savings rate, but at times it can be emotionally difficult, and can even cause problems in marriage or other significant relationships. If you have to pick your battles, go with saving early over saving more later on.
This isn’t meant to scare you or intimidate you, it’s to inform you that the relationship you have with your money will in fact have an impact on your other relationships, no matter what.
Another important consideration comes down to contribution limits. The IRS allows you to contribute $6,500 every year (starting this year in 2020) to an IRA and up to a maximum of $19,500 per year to a 401(k). If you are over the age of 50, they allow you to contribute $7,000 to your IRA or $25,000 to a 401k as a retirement “catch-up.”
Even with the catch-up buffer provided, based on the examples provided above, it becomes pretty clear that this isn’t close to enough to catch up at all. Increasing your savings even by a total of $7,000 for the final 15 years before retirement is too little, too late.
To properly catch up later in life, you will need a multiple of early savings, not the fractional increase encouraged by the IRS.
Compound interest is a much better friend than a higher savings rate. Saving more earlier on must be part of your plan, but saving more later is always better than saving less.
What To Do Next
Cut the fat now and do everything you can to start saving more toward your retirement. Don’t fall for the idea that you can catch up with higher amounts, even if it might be true. If you need light at the end of the tunnel, or need the release of loosening your belt a little, plan on decreasing your savings rate, but plan on doing it closer towards your retirement.
The closer you get to retirement, the more you can let your savings rate fall… But only if you have saved earlier. Hopefully, this will be the emotional reward you need in the future to keep yourself motivated to restrict your current spending and increase your savings.
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