Keeping Perspective - Saving Early

We have all heard someone bemoaning the fact that they wished they had started saving for retirement at a younger age, urging others to do what they did not. Not all advice is good advice, but in this case, it may be the best advice you ever receive.

Beginning to build a nest egg at a young age creates greater financial flexibility later in life. Whether you want to travel, start a business, help kids with college, or retire early, it all becomes more feasible when you are in a strong position financially.  

The biggest reason to save early is to take advantage of compounding. Compounding is earning interest on your initial investment plus, in the next year, earning interest on your interest, and so on. Over time, compounding allows your portfolio to do most of the heavy lifting.

Let’s look at an example using actual market data to illustrate the point.

Imagine an individual that is 65 years old today and who started working at age 22, in 1982, earning $20,000 a year. This person’s wages simply increased with inflation over time, at around 2.8% a year. No big pay increases or job changes. Let’s also say this person saved 12% of their pay every year from age 22 until their retirement in 2025 at age 65. Given a reasonable investment mix over time and using actual market returns, this individual would now have a portfolio of just over $1.5 million. Of that, only $195,000 would have come from their own contributions. The other $1.3 million would have been generated from earnings.

That’s the magic of compounding.

Now that you know how important it is to save early, the question you should be asking is, “How much should I save?” For most people saving between 10% to 15% of their pay, including company matching contributions, will allow them to retire comfortably around age 65. Saving the right amount is critical.

The chart below shows how long you would have to work based on varying savings rates, assuming you start at age 22. As you can see, by saving 15% a year, you could retire in 38.6 years, at around 60 years old.

But think about it this way. If you don’t start saving until age 40 and save the same 15%, you won’t be able to retire until your late-70s, again 38.6 years later. Now, if you delay saving for retirement until age 40 and still want to retire at 60, you will need to save a whopping 40% of your pay (so you can retire in about 20 years). Most people cannot afford to save nearly this much. The only solutions at that point are to make drastic lifestyle changes or to work longer.

Playing catch-up because you delayed saving for retirement at a younger age can cause financial hardships that diminish your quality of life. The great news is that even just starting off with a small amount at a young age will make a big difference over time. You can always work your way up to a higher savings rate.

The key is to start early.

Then, instead of bemoaning your wasted youth, you can tell younger generations to start saving early….just like you did.