Retirement. The word means to “withdraw from”, and if you’re just about to graduate from college, the chances are the word has a negative connotation assuming you’ve even thought about it yet. For many Retirement marks the beginning of the end; it’s something people do when they’re old and can’t work anymore. So it’s probably no surprise that it’s way down on the things to worry about for someone with more pressing concerns such as starting a career, family or just finding their way in life.
I mention this because I was asked a question recently: what did I learn in my 20’s to prepare for a better financial future; or failing that, what I would do differently if I could wind back the clock?
Needless to say, at that age some twenty years ago, I did very little to prepare. I could identify three retirement planning mistakes that I made though.
- I’ll figure what retirement means when I’m closer to retiring.
- I’ll do the minimum for retirement contributions for now.
- I’ll catch up on retirement payments later when I have more money.
The common theme behind all of these was in pushing off any real decision about retirement until later in life and just doing the minimum needed thinking it was enough.
Live now, retire later
The problem for me was that back then, retirement was such an abstract concept and I was busy living with what I call the immortality of youth where you just don’t worry about growing old.
Retirement had a good side to it: “Great, I won’t have to go to work every day” but it also had a lot of negatives too: “I likely won’t be in as good health as today. I don’t know what I’ll be doing or where I’ll be in 45+ years’ time, so how can I make any plans now?”
Retirement = Owning your Life
I’ve learned since then that Retirement shouldn’t be thought of as “the beginning of the end”; it shouldn’t even be viewed as a separate phase of life. In the same way that you don’t feel a year older the day after a birthday, you’re still the same person a day after “retiring”.
So for me the question is not so much, “how will you plan for retirement?” but rather “how will you achieve being financially independent and at what age?” Retirement is simply forcing your hand to be without a job at a particular age. And this means financial independence.
The target age is significant too; I was brought up in the belief that everyone works until 65 and then retires. But it’s possible to retire early if you plan ahead enough; while there’s no guarantee of success since life has its own ups and downs; you’re more likely to be successful, the earlier you start.
Starting a journey to financial independence means investing since cash savings and bank accounts do not provide enough return on investment over the long term to be viable. Fortunately there are a number of different investment accounts such as 401(k), IRA and taxable investing accounts that are easily accessible to enable this journey.
There are other paths to financial independence than retirement or investment income; e.g. starting a side-business. I wish I had thought more holistically about how I might become financially independent at an earlier age when I was just starting my career.
It’s taken me 20 years to appreciate this but I’ve now started a journey to financial independence and this blog is describing that journey. I use a mix of dividend income stocks and low-cost index funds to generate passive income that’s increasing over time.
No thought required?
When I started my first permanent job after graduating I thought about retirement for at least three whole seconds; those three seconds were to agree to pay the standard company Pension Scheme when I filled out the employment paperwork in the Human Resources department. Retirement planning … sorted! It was a similar story for my first 401(k) election in the US.
Now anything is better than nothing when it comes to retirement contributions. But in simply checking the box, you’re relying on perhaps outdated calculations of future retirement expenses. It’s likely that the standard 6% salary contribution will be be enough for financial independence later in life.
At this point in your life, every spare bit of change you can save towards your future will have so much more time to grow. Creating a budget and tracking your expenses allows you to identify how much you can spare and creating a simple process for saving ensures that you will save.
How to save by keeping it simple
The best way to force regular savings is a system where you don’t have to do anything. Regular / automatic deductions from your paycheck where you don’t see the money saved and can’t spend it are the preferred approach.
Most retirement accounts provide for automatic payment plans. The standard advice for people starting towards financial independence is to max out any 401(k) contributions to get any employee matching, then max out Roth IRA contributions. Any additional money ear-marked for retirement after those deductions can either go into your 401(k) or else be held in a taxable account if you want more flexibility at the cost of higher taxes.
How to invest and what to invest in are entire subjects all to themselves. But in general, especially if just starting out, keep it simple with one or two low-cost and diversified index funds or ETFs.
How much money do I need to save?
I would have found it impossible to determine how much money I might need for financial independence when I was twenty. So I didn’t bother.
But now I realize that it’s quite simple and that you constantly build up your answer as you live. It requires you to maintain a budget and track your income against your expenses. The budget allows you to categorize your expenses and know how much you spend and what you spend it on. This is a continual process; your budget will change due to different circumstances and that’s fine.
Tracking your expenses allows you to see the impact of lifestyle choices on your current retirement plans. Doubling your living expenses for example, implies you’ll need more retirement savings if you wish to maintain the same lifestyle in retirement.
Estimating your expected living expenses
Once you’ve worked out your current expenses and how you’re spending money, you can estimate your expected living expenses in retirement as a function of current living expenses (e.g. 60% of them), or with a more detailed estimate (“I’ll own a house by then so no mortgage / rent but higher medical costs”).
You may also need to adjust your expected expenses for inflation – if you’re 35+ years from retiring then you’ll need to double your current values (at a 2% inflation rate, amounts double in value every 36 years).
It’s all a bit of a “SWAG” at this point; the final value isn’t that critical since it’s so far out in time. But managing a budget, tracking your current expenses and projecting retirement amount targets gives you the tools to measure and adjust your progress. The estimates will become more accurate each year. And with 40+ years of budgeting experience under your belt, managing your financial independence will be a breeze.
The rule of 25
As a very simple rule of thumb, multiply your expected living expenses by 25. That’s the target amount you want in your retirement accounts when you actually retire to maintain your current standard of living.
The 25 value is simply the generally accepted rule that you can withdraw 4% of your retirement accounts forever since the investments should grow by 4% a year on their own. The 4% value depends on your asset allocation though – if you hold all your retirement money in a zero interest bank account, it won’t apply.
Withdrawing higher percentages is okay too, but you’re reducing your capital investments so eventually you’ll spend all your money; something you want to avoid if you plan a long retirement period.
Invest Now or Invest Even More later
Even now, my parents ask me what age I plan on retiring. And it’s likely going to be 65, so that’s at least another 20 years down the road since I didn’t start earlier.
When my work took me to live in Germany, I gave up on any real retirement planning. It was a different country and I didn’t have much money left over at the end of the month. I just figured I could catch up on retirement contributions later as I didn’t plan to be in Germany forever.
In hindsight, kicking the retirement can down the road is always a bad idea. It’s the retirement equivalent of high-interest credit-card debt. Yes, you can always catch up but you’ll need to spend a lot more money to do so. How much money? Let’s take a look using three fictitious people.
- At age 25, Elena Early invests $4,000 a year in a Roth IRA for 10 years and stops investing. Total investment $40,000.
- At age 35, Terry Tardy invests $6,000 a year in his Roth IRA for 30 years and stops investing. Total investment $180,000.
- At age 45, Larry Late invests $12,000 a year in his Roth IRA for 20 years before he retires. Total investment $240,000.
Who has the higher amount when they reach age 65, assuming an annualized investment increase of 6% every year? Let’s plot it and see!
Terry ends up with $502,810 and Larry with $467,913 whereas Erica ends up with $562,367. That’s 12% more than Terry despite starting 10 years earlier and making less than one quarter of his investment. For Erica, that $40,000 total investment will pay her an annual $20,000 a year throughout her retirement.
Both Terry and Larry could invest more money than the amounts I’ve shown and overtake Elena’s value; the point here is just to show how a relatively small amount requires a significantly larger portion (up to 6 times larger for Larry) to catch up.
Online tools and services
I’m a very happy Vanguard investor although my 401(k) is at Fidelity. I do all my financial planning myself but it is possible to get support from the professionals if you need extra help in setting up your retirement plans and managing your investments.
Advisory / management services typically take a small percentage of the assets under management as a payment. Note that these fees are usually in addition to fees charged from holding mutual funds, so check the fee structure of the management company if you’re interested in this approach.
Vanguard have recently added a new low-cost advisor service but it does require a $50,000 minimum account.
Personal Capital is a great resource providing online account consolidation, budgeting, portfolio reporting and planning tools like this net worth Calculator. They also offer financial management services for a fee too. I do have an account with them which I use infrequently but I have never used their management services.
Betterment also provides investing management services, but not the budgeting aspects of Personal Capital. I do not have an account with them and have never used their service.
You might not have much income when you’ve just graduated. But you have plenty of Time and that’s the most valuable currency of all. Spend it wisely and take steps towards financial independence as early as you can! Retirement isn’t withdrawing, it’s simply living independently.
An Aside: Present and Future Value
There are many different financial planning calculators on the web and these can all be useful. One thing to keep in mind is how the value of money changes in the future; I tend to do my calculations in the present. Some calculators include this, some don’t. Here’s a simple example to show you what I mean.
Let’s say I’m 25 and my current living expenses today are $40,000 a year. I plug my 401(k) contributions and balance into a retirement planning calculator and it tells me that when I’m 65 years old, my 401(k) should be worth $1,000,000. That means I’ll be a millionaire when I retire in forty years’ time, and at first glance I’ll have enough money to last at least 25 years until I’m 90 if I spend $40,000 a year.
Be careful with these numbers though since the $1,000,000 is the dollar value forty years in the future, and the $40,000 is the dollar value today. Even though it sounds a lot of money, you won’t be able to buy as much with a million dollars in forty years’ time as you could with a million dollars today because of inflation. Likewise my $40,000 now won’t buy as much in forty years’ time.
To compensate you either need to add inflation to your living expenses (e.g. $40,000 now will likely be $88,000 in forty years’ time), or remove inflation from the projected retirement balance. I usually reduce the projected yearly increases of investments by 2% (the average inflation rate) in any such calculator so I can do all calculations with present value.
In an Excel formula you’d write =40000*1.02^35 to convert 40,000 to a future inflated value where 1.02 is the 2% inflation and 35 is the number years to project.
In the example above, lowering the 401(k) growth by 2% annually reduces the final amount from $1,000,000 to $473,000. This means I’d have funding for at least 11 years instead of 25 years. It doesn’t matter which number you adjust; as long as you’re comparing the same values.
Quote of the Day
Guess what? I got a fever! And the only prescription.. is more cowbell!