Most writings for advisers are directed to helping clients in or near retirement, for the same reason why Willie Sutton robbed banks: That’s where the money is. But Boomers have been abysmal savers, with only a minority financially prepared for demographic inevitability. More attention is due to those just entering middle age, who still have the time to avoid their parents’ mistakes. This column is the first part on Young Investors and is directed at clients in their 20s through 40s.
You have an enormous advantage over those a generation older: You have time to prepare, and time to let compounding work for you. In terms of portfolio planning, the conventional wisdom is sound: Save aggressively, invest in equities, diversify through mutual funds and ETFs, and gradually reduce your equity exposure as you approach retirement. This is a lifelong task. But the journey should begin with a few specific steps.
Estimate Your Retirement Income Requirement
If you don’t know where you are going, you won’t know when you get there. Millions of your parents and grandparents did not save enough because they never did the basic arithmetic.
Start with Bengen’s 4% withdrawal guideline as a default goal, although the new normal suggests that 4% may be too generous and 2.5 to 3% more prudent. If all or nearly all of your retirement income will need to come from your own assets—very likely as the few remaining pensions fade into oblivion—plan on amassing 20 to 30 times your target income. In round numbers this will require you to have accumulated about 10x to 15x your wage income by age 45, adding about an additional 5x each decade thereafter through continuous savings and investment growth. These are significantly more aggressive savings targets than are customary, and vastly more than your parents achieved.
Really “Get” the Arithmetic of Compounding
Advisers often introduced you to the power of compounding with a version of the story of twin sisters: one invested early and stopped early, while the other started late and invested continuously thereafter. The frugal sister ended up with a nest egg over 50% larger—because it had compounded for 10 years longer. Everyone we have met who has been exposed to this comes away profoundly changed. Warren Buffett, for instance, has very frugal habits because he realized very early that spending $1,000 now forecloses about $10,000 in a decade.
Buffett and Berkshire Hathaway have earned nearly 20% per year for six decades. Your returns are almost certainly not as impressive, so compounding’s effects aren’t quite as dramatic. But simply holding a diversified basket of stocks like an index fund has doubled its value in seven years, increased by eightfold in 20 years, and by thirtyfold in 35 years.
Run a spreadsheet to project a portfolio at a few hypothetical rates of return. Learn the “Rule of 72.” Really “get” the power of compounding. Self-discipline will not seem so difficult when you realize that your $4 daily work latte that costs you $1,000 a year now is robbing you of the price of a good new car in retirement—every year.
These aggressive wealth milestones can be met if you start early and let the power of compounding turbocharge your assets. But the engine needs fuel—you need to save significantly, especially in your early years (when compounding has the most time to work its magic.) Planners talk about savings rates in the range of 10% to 15% of gross income. We recommend even more, like 25% in your 20s and early 30s, gradually relaxing to 10% to 15% by around age 40. If I could turn back the clock I would save 40%+ of my income in my 20s and early 30s when compounding will offer the greatest leverage), scaling back to a much lower percentage in my 40s.
“Fourth quarter” spikes in savings in your 50s and 60s will be the least effective because it has the least time to compound. Better to exercise severe discipline early so you can relax in middle age.
All of this savings does not need to be earmarked for retirement; it can reasonably be devoted to any appreciating asset, including a primary residence or a university degree. Just be honest with your- self about which purchases are actually assets that produce a return (income), and which are really consumption.
Philip J. Romero, a finance professor at the University of Oregon, and Riaan Nel are authors of “It’s the Income, Stupid! 7 Secrets for a Stress-free Retirement” (Post Hill Press, 2017).