Money Now or Later – New Rules for Retirement Planning
When it comes right down to it, retirement planning is all about deferring current income so that someday in the future when you choose or are unable to continue working you will have sufficient wealth accumulated to support yourself. Conventional wisdom has always held that you should start saving early and defer 10% of your income to build a sufficient nest egg for your golden years. This is reinforced by the federal government as well in the form of tax preferences for retirement vehicles such as, 401k plans, IRAs and other cash or deferred arrangements (CODA) as well as why the government holds back 6.2% (12.4% for us self-employed) of every paycheck for Social Security. Of course the opportunity cost of this is that you must give up some of your disposable income currently that you would otherwise be using to enjoy and experience life now. The argument here has always been that giving up a little now (passing on going out for a nice dinner, deferring big ticket purchases like a new car, etc.) will pay off in the end when you get to spend your retirement travelling, taking cruises and playing golf. The dilemmas though is that many activities that you may desire to engage in may not be suitable in your older years as your health or other factors may limit what you can do. As life expectancies continue to increase and with the insolvency of the Social Security system most have also come to realize that retirement may include some part-time working or consulting to make ends meet which may infringe on the freedom that was once associated with retirement. So with all this in mind, what should those early in their careers do when it comes to saving for retirement?
I personally followed the conventional wisdom for the first 10 years that I saved for retirement. Once I had been working for a few years and my finances had stabilized I actually increased my savings from the requisite 10% to around 20%. When I got married my wife began contributing a similar amount as well. Our thinking was that by doubling up so to speak on the savings, we would have a better shot at being able to retire early. The reality though is that because of the time value of money it is unlikely that you will be able to significantly move up your retirement date based solely on the earnings and contributions you make to your retirement account. This is because the major growth in your retirement account occurs in the later years. For example, if you start with a $25,000 investment that earns 10% a year, you can expect it to double in about 7 years to $50,000 (applying the rule of 72). 7 years later that $50,000 will double again to $100,000 which is still a far cry from the $1M or $2M you are going to want to accumulate for retirement. 21 years from your initial investment you get to $200,000, in 28 you’re at $400,000, in 35 you’re at $800,000 and when you finally get 42 years down the road you hit $1.6M. So based on this the earliest you might even consider retirement is some 35-42 years after you start. For some that might be an early retirement but for most who start saving in their 20’s you’re looking at your 60’s. At this point you may have noticed the example above is based on a one-time lump sum investment of $25,000. This might lead you to argue that the reality is that retirement savings occurs over a number of years where you are making contributions each year that are then compounding on top of each other. Although this is true, keep in mind that the contributions you make later in life will have less time to compound and because you will be nearing retirement age those later contributions will likely be in more conservative investments thus growing even slower. Also to provide some perspective, by following the traditional approach of putting away a percentage of each paycheck it took me nearly 5 years to save my first $25,000.
By the end of 10 years between my wife and I saving at an increased rate of 20% of our annual income we were able to accumulate $125,000 in retirement savings. Although we took great pride in this accomplishment we were nowhere close to an early retirement and I personally wondered at what sacrifice had this been made. What opportunities had we foregone? I also came to question that if early retirement was not achievable by means of traditional retirement investing methods, does it make sense to continue socking away 10-20% a year. After running the numbers it became clear that with the $125,000 that had already been accumulated, we had already hit a critical mass. All I had to do was keep it invested and by the time I reached normal retirement age it should have increased to around $1.8M. That of course assumes an annual rate of return of 10% over 28 years. Since in reality the retirement portfolio may not hit 10% each year I needed a way to insure that the account accumulated as planned. Thus I adopted a target pension plan strategy. With this approach I no longer make any retirement contributions unless, at the end of the year the retirement account has not accumulated 10% over the beginning of year balance. In the case when it is short, I make a one-time annual contribution to bring it up to the level it needs to be at to stay on the targeted 10% return per year. So for example for 2010, the account balance starts at $125,000 so my target earnings are $12,500. By the end of the year the account needs to grow to $137,500 in order to stay on target. If it only grew to $130,000 then I will make a $7,500 contribution to bring it back up to the target amount. If it is over than that acts as a buffer against future year’s when/if there is an underperformance.
Many of the rules for traditional retirement planning still apply to this approach. Most importantly starting early is the key to making this or any retirement plan work. As described above, it’s the dollars that you put in during your 20’s and 30’s that are going to really grow into something formidable. Everything after that is just playing catch-up. Whether you put in 10% or 20% in your initial accumulation phase will be a factor in how quickly you hit the point of critical mass where you don’t need to really fund the account anymore and can just let time and the market do there work. As noted above if you go for 20% you are definitely going to have to make some sacrifices (I have been driving the same car for the last 10 years) but it won’t make you a pauper either (my wife and I have been to Hawaii twice and the Bahamas in that same time period). Some of you may question whether you would have the discipline to make your annual target contributions in down years without the benefit of payroll deduction. I would suggest continuing your payroll deduction but instead of placing it in the retirement account have it deposited in an interest bearing money market account. At the end of the year, if you hit your target retirement account balance use the savings to pay for/off your Christmas gift giving expenses or to go on a nice vacation the following year.