One of my clients recently took advantage of my offer to sit down with and advise his daughter. This young woman was 25 years of age and just getting started with her career. Along with eliminating consumer debt, it was clear that the most helpful advice I could provide was to save early and save often.
Since the status of Social Security when this young lady retires in more than 40 years is uncertain, my advice was to take control of her own retirement planning. Of course, any benefit that Social Security provides will be a welcome supplement, but it may be wise for young individuals to take full responsibility for ensuring their retirement income needs are met.
To illustrate the importance of saving, I asked this woman how much money she currently spends each month. After including rent, a car payment, and all other expenses, we found that she needed about $3,000 per month – or $36,000 per year - to cover her costs. First and foremost, we calculated the impact of inflation on her retirement planning. Assuming a 3% annual inflation rate (which has been about average over the last 100 years) we determined that in 40 years, when she is 65 years old, she will need $9,786 per month – or $117,433 per year – to maintain her current standard of living. As you might expect, the impact of inflation alone was enough to catch this individual’s attention.
We then discussed how long she expects to live. Of course, we agreed that running out of money was the last thing she wanted to happen, so she wanted to ensure she has enough funds to support her through 30 years of retirement, from age 65 to 95. Keeping in mind that we wanted to be confident that her funds would last, we assumed she would have a relatively conservative portfolio during retirement and selected a nominal (pre-inflation) 6% rate of return on her investments. Given a nominal 6% return and an inflation rate of 3%, we calculated that the real (inflation-adjusted) rate of return on her investments would be 2.91% (calculated as such: (1.06/1.03) – 1)). Thus, if she wanted to have the ability to spend an inflation-adjusted $117,433 per year between ages 65 to 95, and her investments were earning a real return of 2.91% over this time period, she would need to have $2,328,748 saved when reaching age 65. Again, as you can imagine, this figure raised some eyebrows as well.
Finally, we asked what this woman needs to do over the next 40 years to establish a nest egg of $2,328,748 by the time she retires. As this individual can afford to take a little more risk with her portfolio because she has 40 years until retiring, we assumed her portfolio could obtain a nominal rate of return of 8% during the accumulation phase. Still, even assuming an 8% return and knowing she has 40 years to save, we calculated that this woman would need to save $8,989 each and every year in order to develop the nest egg she sought after.
Naturally, the young lady was concerned about this rather large savings figure that would be required in order to enjoy what seemed like a relatively basic standard of living during retirement. I used this opportunity to illustrate the importance of taking advantage of any employer match provided on her company retirement plan. Of course, if an employer provides a 100% match on employee contributions to a 401k plan, this could cut the amount of savings required by the young woman by as much as half. I also reminded the individual that people’s ability to save commonly increases as their career progresses because earnings tend to increase while consumer debt and student loans tend to decrease.
However, it was vital that the young woman understood the importance of beginning to save as early as possible. To illustrate this point, we preformed the same calculation assuming she waited 10 years, or until she was 35, to begin saving. To have the same accumulated nest egg of $2,328,748 at age 65 but waiting 10 years to begin saving, she would need to invest $20,556 each and every year between 35 and 65. Conversely, if she had started to save five years early at age 20, she would only need to save $6,025 per year. Clearly, every lost year increases the amount of necessary savings dramatically.
In reality, very few 25-year-olds can contribute $8,989 per year to retirement accounts. However, the lesson is to save early and save often, and that taking full advantage of any employer match offered within an employer’s retirement plan goes a long way. Any small amount contributed early drastically reduces the retirement saving burden later in one’s career.