I feel a little foolish writing this blog post because the stuff I'm about to talk about is readily available information. Countless articles are written on this all the time. Despite this, time and time and time again, I run into folks who just haven't absorbed this. I draw up a simple spreadsheet and show them some simple calculations and they are utterly stunned at what is possible with tools that are easily within their grasp.
So, if you're already on your way to being a millionaire or multi-millionaire, please forgive me. If you aren't, or aren't sure, please read just a little bit farther.
I'm going to focus on one aspect of retirement / wealth accumulation: retirement accounts. By this, I mean 401(k), 403(b) or TSP, depending on which one your employer offers. It is not uncommon for some employers to offer a match of some sort. However, I'll provide some figures that don't involve a match just for the sake of illustration.
Let's take a typical mid-20-something who has finished school and embarked on a career. Let's set their initial earnings low. So, let's talk about a 25 year old who makes $25,000 a year.
For the sake of this model, we'll increase this person's earnings at about 4% per year for their entire career. Yes, it's true that a lot of you don't get very good pay increases in your jobs. However, generally speaking people's earnings go up over their lifetime. Every now and then you change employers and get 15% more, or you get a promotion and get 10% more. For the sake of simplicity, though, we'll set this person's annual increases at 4%.
This person will put 5% of their annual salary into their retirement account. So, for instance, in year 1, they will contribute 1,250. Now, bear in mind that this contribution is tax-deferred. So, although $1,250 goes into the retirement account, it's going in as pre-tax dollars. Basically, if they didn't make this contribution, they wouldn't get that $1,250 to spend. They'd get whatever the after-tax amount would be. So, what, maybe $1,000 or so.
I will also presume that this person invests their money into something like an S&P 500 indexed fund. Over the long-term, we'll presume this person gets 10% annual return from their fund. (Yes, I know this is a very controversial assumption, especially after the debacle we've seen in the stock market this century. However, the historical rate of return of the Dow over a long enough time frame is about 10%. So, I don't think that's an unreasonable assumption.)
Okay, so this person plugs away, always putting 5% of their pay into their retirement account. And after 10 years, their account will equal about $25,000.
After 20 years, it equals over $100,000.
After 30 years, over $300,000.
After 40 years, when they are 65, it will be over $900,000.
When they reach full retirement age at 67, it will be over $1.1 million.
Now, this raises a few questions:
1. Are these assumptions realistic?
Well, if you ask me, this model is exceedingly conservative in terms of this person's lifetime earnings. The only assumption that might be a stretch is the 10% return from the stock market. I have no idea what the stock market will do over time. I just know that people tend to innovate and create wealth over the long haul. This results in stock prices tending to go up. Over a long enough time frame, a broad-based index increases at roughly 10%. So, that's why I use that number.
2. Okay, $1.1 million in 42 years? But what will that be worth after inflation?
A reasonable answer there, in my opinion, is that inflation appears to be getting lower and lower over time. But a reasonable historical rate of inflation would be, say, 3%. You can use any presumption you want, but my gut feeling is that 3% is more than inflation will actually be over the next 42 years. So, if we adjust for inflation, $1.1 million will have modern-day purchasing power of over $330,000. So, basically, a million dollars will be a lot of money, even 42 years from now.
3. $330,000 doesn't seem like that much of a secure retirement. How can I feel good about that? That's not much of a brass ring.
No, it's not a brass ring. You won't be able to buy human slaves or a mansion. But don't forget that you'll also likely be collecting social security. The combination of the two will probably provide for a reasonable and secure retirement. Don't believe folks who say social security won't be around. That's alarmist and even the most dire predictions don't include a scenario where social security disappears. The absolute, worst-case, Armageddon scenario I've ever heard of was where benefits were reduced by 30% and no serious government official has ever proposed that.
4. No, seriously, that sounds like a pretty bad scenario to me. What gives?
I can understand this perspective. Just keep in mind that many of today's retirees would be doing back flips if they had $330,000 in the bank.
But if you want to improve your wealth at retirement, there are other things you can do:
a. Work for an employer who will give you a match. For instance, my employer matches the first 5% I contribute basically dollar for dollar. When I owned a small company, I provided a company match for my employees that was pretty much the same. The large employer I worked with before that matched my first 5% of contributions with an amount equal to another 4%.
So, let's jigger the formulas for an employer who throws another 4% in for us. If you do that, this worker, when they turn 67, will have over $2 million with an inflation adjusted value of about $600,000.
b. You don't have to put 5% of your pay into your retirement account. You can put in 10%.
This has a similar impact to getting a match. So, presuming an employee who gets 0% match, if you put in 10% of your pay, you end up with about $2.3 million at retirement or an inflation-adjusted $660,000 or so.
c. Do both. Put in 10% AND get a 4% match.
At this point, you're hitting on 6 cylinders. You will end up with about $3 million overall and inflation adjusted, over $900,000.
So, the potential is there to accumulate tremendous wealth. But even putting away 5% is enough to change your life. Now, there are obviously other things you can do to make for an even better retirement. You can work for an employer with a bigger match. You can work in higher paying fields. (Let's be frank, the $25,000 in the example isn't exactly what most college grads envision.) You can try to work in a field that has a genuine pension.
Those are all things you can do without taking extraordinary risk by starting your own business or heading off to try and work in a Silicon Valley tech startup.
What if you're already halfway down that road? Hey, you have to jigger the numbers for your particular circumstances. Now, yes, there are ages where it probably is too late to start. If you're in your late 50s, you really can't leverage time like a younger worker can. But even with as few as 20 years left in your working life, it's easy enough to construct a scenario where you retire with a million in your retirement savings account. You will probably have to lean heavily on earning more money and putting away a larger percentage of your pay.
Especially if you're young, though (and to me, "young" is pretty much anybody in their early 50s or younger), start saving now. Don't despair. The impact is real and you can retire very comfortably.
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