saving for retirement
The miracle of compounding interest:
I am 27 and currently have ~100k in 401k savings and currently contribute $15k/year (numbers approximate for the sake of argument). If I invest in the laziest way possible (say, index funds for US markets, world markets, and real estate) until retirement, how much longer do I need to save at this level so that I can stop saving completely and have a comfortable income at 65? We'll discount the possibility of the entire world's economy crashing only because that is not a useful scenario for the sake of this exercise.
I'm thinking that if I conservatively assume 6% returns, if I save another 15k for the next 5 years or so, I should end up with 1.5 million for retirement, which is enough.
Crazy.. am I really that close to not having to worry about retirement? My parents are financial planners and basically told me to save for retirement first.. looks like the miracle of compounding interest makes that good advice.
the great purple
April 27th, 2007 8:57am
I have no advice to offer just wanted to say fair play, everybody I know in theres 20's doesn't save a penny (including myself) wow
what are you reading for?
April 27th, 2007 9:00am
You must account for inflation.
Your effective interest is the difference between nominal interest and inflation.
In the future there will be a period of heavy inflation (when China starts selling dollars).
When nominal interest keeps up with inflation you are fine, but when there is a period when it goes out of control, your savings can melt away fast.
It happened around 1930 in Germany, in the early 1990's in Russia, and in countless failed countries.
1.5 million may not be that big a deal in 2040.
April 27th, 2007 9:26am
> I'm thinking that if I conservatively assume 6% returns
Do you think you'll be earning 6% every year or that in n number of years, you would've had a simple average return of 6%? If the latter is the case, real compound average return may be much lesser. Naturally when people advertise their funds they'll use the simple average return and not the compounded return.
See the table Impact of Dispersion of Returns in the following link:
I guess assuming 6% compound return is not a conservative return. It's a good return. Of course, I assume this will take into account inflation too.
April 27th, 2007 9:36am
6% for retirement investments at age 27 is *very* conservative. She should be aiming for 8-10% average returns.
April 27th, 2007 9:41am
Her advantage is that she's starting at age 27.
Something I've been looking for, but haven't been able to find hard info on, is expected expenses once you retire (stuff like medical costs).
I heard that your medical costs in the last 3 years of your life can exceed what you paid up until that point.
April 27th, 2007 9:50am
..my point was that you need a target to save for.
How much will I be spending once I turn 72?
April 27th, 2007 9:52am
Inflation is the problem. If you make 6% returns ABOVE INFLATION, you'll do excellent. With inflation around 5%, that's 11% right now, which is not really do-able.
If you make 3% above inflation, you'll do OK. That's 8% these days, which is not unreasonable.
If you make 5%, you're AT inflation, and treading water. And if inflation is higher than your returns, you're going backward, and you get the Germany 1930's syndrome.
The point being, whatever analysis you look at, it's important to factor inflation in. I know, it's hard to predict future inflation. But leaving it out entirely can be disasterous.
April 27th, 2007 10:03am
Oh, and $100,000 at age 27 (or even 30) is excellent. Now factor in housing costs, children education costs, and what the inflated value of your retirement income needs to be.
April 27th, 2007 10:05am
> She should be aiming for 8-10% average returns.
Yea. I agree. I should given this percentage rather than saying 'Of course, I assume this will take into account inflation too.', which wasn't clear I guess. Inflation varies and 6% real return will fall into 8-10% return.
But my main point was it is difficult to do this consistently, year over year, for even 10 years, save for longer periods. People, when they talk about compounding, see only the way it goes higher. It can go the other way too. The way it is indicated in the above link, on average, the simple return can stay at 10% or so but the real compound return be much lesser.
One single stroke on the negative side may easily wipe off a lot of return earned for quite a few years.
> Her advantage is that she's starting at age 27.
One more assumption people make regarding compounded return. Naturally, earlier is better. But there are instances where the time you get in may be bad. Not all sons are better off than their fathers in their earning power or career, etc.
It may be the case that someone gets in early and makes a bad return and another gets in late and make a good or even much better return. As being there when the going is good is important, not being there when the going is bad is as important too.
In the book "Bull" by Maggie Mahar, there are examples given where people have burnt their fingers getting in early at different periods. I don't have the examples readily. But it talks about investment, retirements, 401k, etc.
April 27th, 2007 10:06am
"But my main point was it is difficult to do this consistently, year over year, for even 10 years, save for longer periods."
Some years it may be 3-6%. Many years can be 12%+
April 27th, 2007 10:09am
The size annuity you can buy with $100k would only pay about $600/month. The reason you purchase annuities is to mitigate the risk that you will outlive your money. If your money runs out when you're 85, there are very few jobs you could get.
Real estate is a very risky investment as many of the house flippers are learning now, and many more will learn in the coming years. Unless it is bringing in money, namely rental income, it isn't an investment.
Another risk you might not have considered is divorce. Some community property states will split your IRA and give half to your ex.
Defined contribution plans - namely 401ks - haven't been around for a long time. Less than 2 decades. I suspect that not all the legal issues, especially with bankruptcy, have been worked out. Defined benefit plans - traditionally called "pensions" - had been around for more than half a century before the big Studebaker bankruptcy that wiped out large numbers of pensions and lead to PBGC. PBGC doesn't cover 401ks, and as the Enron folks learned, it can all go up in smoke when the company stock goes tits up.
April 27th, 2007 10:17am
This is where Excel really can help as you can model discounted cash flows quite precisely.
A simple first cut would assume you will save a fixed proportion of your earnings and your earnings rise over time. Add in interest (NET of management fees!) as it accrues to your accumulated principal. Stop at your selected retirement point for the the future value of your diligent savings. Looks huge, eh? But that's in future money where a sandwich costs $200. You need to convert the future value to todays' money to get some idea of what it represents in current value.
You can then elaborate - factor in varying rates of inflation, varying income and expenses etc.
April 27th, 2007 10:34am
It seems a fairly simple intersection of two bands in the Cartesian plane:
- take $100K at year 27, add $15K/year going forward, and compound at 5-7% (which is a fair guess at what an after-inflation moderate risk interest would be).
- start at death, add somewhere between $X1 and $X2 per year going backwards (discount 6% for interest gained on this amount too).
The two bands will overlap in a diamond shaped figure with curvy sides. Hopefully the year 65 either intersects this diamond or comes after it (early retirement!).
The problem is forecasting your own death. And calculating those Xs. I heard a program on NPR that said retirement expenditures used to be calcluated at 70% of peak income (not age 27, but peak). But retirement advisors are now upping that to 90%. Don't ask me how someone making say $80K a year is supposed to plan a retirement where they spend $72K a year.
Peter points to an interesting first estimate: let the statisticians/free market do it, ask an annuity (a reverse life insurance plan) to tell you how much they'd pay you per month for your $100K.
They have the acturiarial tables, they can do the work fairly quickly (and their 10-20% profit margin is easy to take into account as well). Granted this is not a safe number: an annuity can risk letting a few old geisers live longer than predicted at a loss. You have less risk being such an old long-lasting geiser when it's mostly you paying the bills (though Social Security and kids offer a safety nest).
April 27th, 2007 11:58am
Taxes on unearned interest could be regarded as a "mamagement fee" ... but good point well spotted.
April 27th, 2007 12:01pm
> Some years it may be 3-6%. Many years can be 12%+
True. But the problem is some years it may be negative too and the order matters.
Year 1 = 5%, Year 2 = 25% and Year 3 = 0% gives 9.49% compounded average.
Year 1 = 30%, Year 2 = -20% and Year 3 = 0% gives 9.49% compounded average.
Year 1 = 40%, Year 2 = 30% and Year 3 = -40% gives 2.98% compounded average.
All of the above will give a simple average return of 10%.
By averge, which average do you mean? It can either be simple average or the compounded average. Simple average looks good but the real return (what you'll finally end up with) is the compounded average.
April 27th, 2007 12:04pm
Wow... lots of numbers. To answer one person's question, you would expect your expenses to go down as you approach retirement, because most people pay off their homes. Therefore no more rent/mortgage. Also, a portion of your income is no longer going towards retirement savings.
However, health insurance costs go up and you might want to travel so maybe that evens it out. Also, you expect SS to kick in for some portion of your income. So my guess would be that they expect that to cover the gap. Maybe they're expecting SS benefits to go down, and that's why they're recommending people save more?
There are too many unknowns in this whole "how much do I need" discussion. I don't know what inflation is going to look like, nor what my returns on investments will be. To be on the safe side I have to assume high inflation and low returns. I have no idea what my pre-retirement income will be. I know what I make right now, but will that go up or down with time? No clue. Will I want to travel? I really don't know. I don't have dreams of travelling, per se, but maybe I'll develop some? What will my medical expenses be? A HUGE question to which I have no answer.
The end result being, it's pretty much impossible to plan. This irritates me to no end.
the great purple
April 27th, 2007 12:59pm
It may be impossible to plan, but too many people use that as an excuse to do nothing.
It’s highly unlikely you will arrive at retirement age regretting having saved and invested to prepare for it.
Just don’t get conned into living like a pauper in order to accumulate huge amounts for your retirement years. This is typically the advice given by people who stand to gain commissions and fees from you doing so. Planning your retirement so you can live on much less income than you have now is possible, but there is no money in it for them to tell you that.
April 27th, 2007 2:46pm
401ks haven't been around that long, but they have been around long enough for people to retire with them. you have to watch out. There are lots of ways things can screw up and you'll end up losing most of it. Banks will 'misplace' your accounts. Or you'll transfer from one bank to another, and mistakes will be made and you'll end up with full tax liability for the entire fund value in a single year, wiping out nearly half of it in one move. Be extremely careful.
April 27th, 2007 3:34pm