Over the years, studies have thoroughly researched and exhaustively footnoted what most of us already know. Americans typically don’t start seriously thinking about saving for retirement until they near their own mid-century mark.
After snoozing for decades, our middle-aged Rip Van Winkles suddenly awake with a jolt to see the financial equivalent of a fully loaded pallet of cinder blocks heading right toward them. That often gets their attention.
What can happen next is the really ugly part. The savings slackers may ultimately find themselves pulling the equivalent of a college all-nighter for the rest of their working lives in an attempt to financially prepare for the day when the paychecks stop.
If you’re still young, there is a simple way to avoid this unpleasantness. Save early and get it over with. And then, if you want, you can slack off. In fact, if you invest early and then stop altogether, chances are you’ll be financially better off than your friends, who may ultimately work themselves into a full-blown money panic.
Of course, the best strategy is to save early and contribute regularly to retirement accounts, such as 401(k)s and Individual Retirement Accounts, and continue that habit for decades. But for those who find that too onerous, the early-bird approach can work. If you’re skeptical, here’s an example of what I’m talking about:
Suppose a 25-year-old decides to save $5,000 a year for retirement for 10 years. After saving nearly $100 a week for a decade for a total of $50,000, our investor calls it quits. She doesn’t dump any more cash into the account, but she does not withdraw any either. Left alone, the portfolio, if it generated an annual 10% return, would mushroom to $1.4 million by the time she hits 65 years of age. Not bad for just 10 years of sacrifice.
Now let’s examine the fiscal fate of someone who doesn’t roll out of bed until the age of 35. Our Gen Xer starts saving $5,000 a year, but admirably this guy stays committed for longer. Instead of feeding the retirement kitty for 10 years and bailing, he maintains the routine for 30 years. After three decades, our earnest saver will have chipped in $150,000. At this point, you’re probably thinking that this guy started later, but certainly finished stronger than the 25-year old. Of course, if that was true, it would make this column less interesting. Actually, the portfolio of our more energetic saver, assuming the same rate of return, would ultimately grow to $820,000. That ending balance is 40% less than the portfolio of the woman who bailed early.
Things start resembling the crash scenes captured in driver’s ed movies when you look at the fall out from baby boomer procrastination. If boomers waited until age 45 to launch their retirement-savings assault, they’d have to save $24,000 a year for two decades to catch up with the efficient 25 year old. But that’s not as bad as the savings fortitude that somebody, who began saving at age 55, would need. He’d have to save $87,000 a year for a decade to amass $1.4 million. How man people can find a spare $87,000 hidden in their household budget?
The reason why it’s better to save early can be summed up with two words: compound interest. So marvelous is its financial force that legend has it that Albert Einstein once called compound interest the most powerful force in the universe.
Thanks to compounding, the returns on your savings are consistently plowed back, making the principal bigger and thereby producing a snowball effect on the portfolio. Essentially, there’s a logarithmic expansion that takes place. Without getting into the math, compounding let’s a portfolio grow just as a seedling would. If a seedling grows 10%, it adds barely an ounce of weight. But years later, as a giant oak, 10% growth may yield a ton of new wood.
Compounding can be hard to appreciate because people tend to think in terms of linear growth [2,3,4,5…], not the geometric kind produced by compounding [2, 4, 8, 16…]. That is, we expect to see $100 grow by $10 annually over 10 years to produce a $100 gain. In contrast, compounding, using a 10% annualized return that is reinvested, produces a $159 gain over 10 years.
If you don’t have decades to sit on the sidelines and watch compounding do it’s thing, you may need to adjust your investment strategy. You can start by examining how much you pay for the investments in your portfolio. You see, compounding cuts both ways. If you’re invested in expensive mutual funds and variable annuities, the costs will become more painful, thanks to compounding, as the years go by. Getting rid of some of the cost drag by switching to inexpensive mutual funds will help your nest egg grow faster. And, of course, the best time to get started is today.