Tuesday, May 29, 2007

Save money for retirement - avoid these pitfalls! Part II

As previously stated, due to an uncertain future of tax rates, health insurance costs, college costs for kids, changing government regulations, and increased life expectancies, I believe it is near impossible to predict how much we'll actually need to save for retirement. Therefore, the amount you need is A WHOLE LOT! That's all you need to know - you need A LOT. And if you need a large pile of money for retirement, you need to start saving now. The sooner you make the pile of money "sorta big," the bigger it will be upon retirement.

Here is the second pitfall that I believe you need to avoid on your road to retirement:

2. Believing it's OK to start investing later in life - waiting to begin saving.

You've heard it said a million times - the magic of compound interest is the key to amassing the money you need for retirement. Still, many people, for many reasons, delay saving until some time later in life. One reason might be that they have material things they'd rather spend the money on now. Another related reason might be a general lack of discipline with regards to money. Still another related reason might be a lack of a vision for the future, a lack of a plan for retirement.

My favorite reason for delaying retirement saving is psychological - "I'm young, I can only save $200/month, and that's nothing! I'm not going to get anywhere saving $200/month - why even bother????? I save $200/month, and I end up with a measly $2,500 or so after a year? Big whoop."

As I am a CPA, I turn to my trusty spreadsheet - run one using the scenario of your choice and amaze yourself with the results.

Here's mine: imagine you're 25 and you begin investing $200 a month, assuming an 8% return per annum. With annual compounding (not monthly), you end up with $728,000 by the time you're 65. $200 a month, a conservative 8% return, and you have over $700,000. Keep in mind that the average return of the stock market is over 10%, and you're very likely to be able to save more than $200/month as you age and advance in your career.

Now, assume that you wait until age 30. You wait just 5 years. That's a cumulative $12,000 over 5 years that you did not invest. Instead of $728,000, you end up with $485,000 at age 65, or $243,000 less than if you had started at 25! Holy crap, what happened? Simple - thru this so called magic of compounding, it is beneficial to have your money grow for 40 years instead of 35 years.

What if you wait until 35? At 65, you end up with $320,000, or $408,000 less. Wait until 40, you end up with $207,000.

These results are OK if you want to work well into your 80's! But if you're like me and want to retire in your 50's or 60's, you simply should not wait until your 30's or 40's to begin investing.

What if you do wait? Let's say you wait until you're 40, and you want to get to that $728,000 nest egg that you would have had if you had started saving at 25. You would need to sock away $700/month instead of $200. For many working professionals, this is entirely possible. But why bother waiting? If you're able to start saving earlier, no matter how much it is that you can save, it only makes that retirement pile of money bigger.

Here's my favorite scenario that I use to encourage young people to invest - start at 25, invest $300/month in the stock market. You cross the million dollar mark at age 64. It can happen, if you start early and prove yourself a consistent saver.


PF101 said...

I love compounding. I think it's one of the best things ever. I love explaining it to people and using it in examples in my budgeting classes when I talk about how much financial damage that $100 pair of shoes can do to you over 30 years. Shocks people into thinking twice about spending.


concentrating money in any one investment is the biggest mistake you can make.