Do you know exactly how much money you want to have before you retire? Do you have a plan to get that money? My guess is probably not. But here’s why you should.
Most people, especially fellow Millennials, think about their working career in a way similar to their parents. They wake up, go to work, come home, rinse and repeat. When I ask most people how long they plan to work I usually get an exaggerated eye roll and a drab “forever”. Indeed, most of us have a friend or relative who find themselves in exactly that situation – scratching their heads at age 70, and wondering where the time went. But I don’t think it has to be that way.
If you’re like me, you probably don’t want to work your entire life away, and so I’ve worked on a plan to see how I can avoid it. Here’s how it works:
It all starts with a number. This number is how much you would like to have before you decide it’s ok to retire. It’s ok if you don’t pick the perfect number at first. You’re free to adjust that number up and down as you go. But you should have a ballpark target to focus your efforts.
Here are a few things to think about:
1) The dollar will probably inflate somewhere between 3-4% annually between now and then. This will help you keep in mind that $1 today is worth much more than $1 decades from now and any investment you make with a long term horizon should at least keep up with if not outpace inflation.
2) What does your dream retirement look like? Are you traveling? Eating out every night? Lounging on the beach? – This will help you gauge how much money you will need at retirement. You will hear many experts say to plan for 70%-80% of your income at retirement. I would encourage you to ignore that advice if you A) are still decades away from retirement or B) have ambitious travel plans for your retirement.
3)When do you want to retire? – This will help you gauge how long you will need your money to last. The earlier in life you want to retire, generally the more money you should have saved by the time you retire. You will need more money to last you 30 years in retirement than 20 years in retirement.
4) What is your path to reaching the annual savings necessary to reach your goal? – This will get you thinking about a specific incremental amount of money that you will stash away to reach your goals.
Joe “Future Millionaire” Smith
Meet Joe Smith. Joe is 35 and has a goal to retire by age 65 with at least $1 million in liquid assets (securities and cash). Joe believes that he will probably live into his 80’s or 90’s. So he will need his money to last at least 30 years in retirement. What will it take Joe to reach his goal?
Well, let’s first assume that he’s are starting at zero, making $35,000 a year, averaging 3% raises annually, and he’s are receiving a dollar for dollar match on his 401k contributions up to 3% of his salary. Then, for the sake of easy calculation let’s assume his invested savings will have an average return of 8% over his working career (ideally >8% when he’s younger and <8% as he nears retirement). Take a minute to think for yourself about how much you think Joe will need to put away each paycheck to make this happen.
Got a guess? Using our assumptions above, Joe would need to stash away 14.5% of his income annually to reach his goal by age 65. In year 1, this represents $5,075 or about $423 a month. The key here for Joe is to think about how much he are saving as a percentage of his income NOT a gross dollar figure. It’s easy to see that as Joe’s income grows, by 3% annually in our example, the amount he is saving should grow as well.
If this number seems a bit off-putting to Joe it might be because he’s thinking about it as an expense. And when he starts thinking about expenses, he starts thinking about all of the things he can no longer buy with that $423. But I would encourage Joe to reconsider. I would ask Joe to think about how much MORE he will be able to buy by growing that $423. When he transfers that $423 from his checking or savings account to his brokerage or retirement account (or via salary deferrals), he is not spending that money. He is giving that money the optimal chances of growing overtime. He is investing in his future well-being. To highlight this point consider this: using our assumptions above, by the time he’s reached $1 million in his brokerage account he’s only actually invested (not spent) $241,445 of his own money! Over 30 years he has quadrupled his spending potential in retirement! The question for Joe is, would you rather forgo $423 this month or $764,934.63 thirty years from now?
Ok, but what if…
You might be saying to yourself, “What if Joe pays off bills (e.g. student loans, cars, etc.) for 10 years and then saves more money when he has a larger paycheck? How much would he have to save then?” If Joe does this at age 45, and he still wants to retire by 65 with at least $1million, he will have to save more than double what he would have had to save if he started when he was 35. Running the numbers, Joe now has to save about 31.5% of each paycheck. What’s more, by the time Joe does retire, he will have had to invest about $157,000 more than if he would have started earlier, despite only saving for 20 years instead of 30 years. Why is this? It’s because Joe is forgoing 10 years of compounded annual returns on his savings. Compounded returns that he would have received just by investing the money and doing nothing else.
So what can we take away from Joe and his hypothetical retirement plan? If you take nothing else away, it should be this. The earlier you start, the better you will be and the more control you will have over your retirement options. Even if you don’t have all the other details figured out yet, as long as you are investing money and collecting compounded annual returns your future will be much better off! The money you make at your job represents your time and energy. Think very carefully about what you would like to do with that time and energy.