Everyone understands, at some level, the need to save for long-term goals. Buying a house, preparing for retirement, or sending a child to college are goals that we know we have to save for. But how much difference does it make whether we start saving now versus saving later?
When I began studying to become a financial planner, one of the first books I was required to buy was on “the time value of money.” The effect of earning compounding interest is fairly non-intuitive for most people, so it’s one of the first concepts that’s emphasized when you begin studying financial planning. Few people can do compound interest calculations in their heads, and many don’t even realize that over the years, you earn interest on previously-earned interest.
The Value of $1MillionImagine, for example, that you’d like to have $1 million set aside at age 65 (I know $1 million isn’t what it used to be, but ignore that for the moment). Assuming a 6% annual return rate, if you began saving at age 35, you need to set aside $12,649 each year in order to meet your goal by 65. But if you waited 10 years before you began saving, you’d need to save more than twice as much for each of the remaining years – $27,185 – in order to reach your goal. On the other hand, if you had started at age 25, you would only have had to set aside $6,461 each year.
This demonstrates why it’s a good idea to start saving for retirement as early in your working years as possible. There is also a psychological aspect to this problem: if you can get used to saving a given amount each month early in your working life, it will be much easier to maintain that level of savings than to get used to a higher level of spending for several years and then have to bite the bullet and cut your consumption enough to save an even larger amount.
Sometimes, the now-versus-later question has to be framed somewhat differently. Suppose you’re trying to decide between spending money on an expense that will last for a limited amount of time – something like child care, or loan payments on a moderately expensive item like a boat – versus saving the same amount. You could defer saving temporarily in order to cover the expense and then start saving later, but what would the consequences be?
How Much Does it Matter?Let’s say that you have an expense that will cost you $10,000 a year for 10 years. In effect, you’d be giving up the ability to save that amount of money for 10 years in return for whatever you’re buying. Assuming a 7% return rate, if (instead of paying for the expense) you had saved $10,000 a year for 10 years and then stopped saving, after 20 more years you’d have about $570,000. Now compare that with what would need to happen if you had consumed $10,000 a year for 10 years, and now you’d like to have the same $570,000 in savings available after 20 years. What would you need to do? Well, you could meet your goal by saving $13,000 a year – but you’d have to save that much every year for the remaining twenty years instead of ten. You’d end up setting aside more than 2 1/2 times as much just to reach the same goal.
These examples illustrate why the time value of money is such a big deal in retirement planning, or in any other planning situation in which you have a savings goal to meet. Perhaps the examples also provide a sense of why saving for retirement often mystifies people. Whether you’re saving enough to meet your goal or not, understanding the long-term outcome of a savings plan requires a certain amount of number-crunching – it’s not intuitive. To make the task of planning easier, there are a number of web-based calculators available. Here are a couple of good ones: one is provided by FINRA, the Financial Industry Regulatory Authority, and the other is at Bloomberg, the financial news organization.
The one thing that is certain is that time is always on your side: saving now, rather than later, will always tend give you greater financial flexibility.