Content provided by Kostya Etus, CLS Associate Portfolio Manager
Do you make “to-do” lists? I use them all the time. I use them at work nearly every day to help prioritize my tasks. I also use them at home to make sure chores get done. It is a great way to lighten the burden of things to think about, or better said, worry about. Currently, I am studying for the grueling Chartered Financial Analyst (CFA) examination and am trying not to concern myself with too many other things.
Due to all of this, my wonderful wife has taken it upon herself to create a “Post-CFA To-Do” list for me. She calls it my “Honey-Do” list, which I think is supposed to make me feel better about it. This list has been slowly growing but has not yet become a multi-page document. Still, I am not looking forward to it. One of the items on the list is to review our retirement plan and to determine some factors including:
- Are we taking the appropriate amount of risk in our allocation?
- Are we well diversified among all of our assets?
- Are we contributing enough for our future?
Typically on a to-do list, you would prioritize the urgency of each item. Many seem to put “saving for retirement” on the back-burner, which might not be the best place for it. Some rely on Social Security benefits, but that may not go as far as you may think. The payout may not even be enough to continue a pre-retirement lifestyle. Furthermore, for younger entry-level employees, there may not even be Social Security benefits by the time they reach retirement. It is important to start saving for retirement as early as possible. The small amounts that you add to your retirement now really do add up over time through the power of compounding. Case in point, the earlier you start, the better.
Employers have made it easier than ever to save for retirement by offering 401(k) retirement plans and even matching contributions to a certain amount. The contributions are automatically taken as a payroll deduction and best of all, pre-tax (although you will have to pay the taxes in the future when you take distributions; a Roth account allows contributions post-tax but distributions are tax exempt). Actually, one of the main benefits of these 401(k) accounts is that earnings grow tax deferred, meaning you don’t have to pay taxes on yearly capital gains and income, and this compounds the savings even higher over time. An automatic payroll deduction to a 401(k) can save you from yourself, which is especially useful for those that try to spend every penny they earn.
Compounding is a wondrous thing, but rather than talking about the intricacies, I will just show an example. First let’s make a few assumptions:
- The long-term average for yearly stock market returns is 10.6% and is 5.6% for fixed income returns.
- Diversification is the key to long-term investing, so we will allocate 60% to stocks and 40% to bonds (a fairly moderate portfolio).
- The long-term yearly inflation average is 3.2%. Don’t forget that simply holding onto cash loses you money through inflation’s erosion.
- There are three contribution options: $50 ($1300 annually), $100 ($2600), and $150 ($3900) per bi-weekly paycheck
- We have three investment time horizons: 20, 30, and 40 years
As you can see in the chart below, which demonstrates these assumptions, small increases in contribution amount and time can have a magnifying affect. These incremental savings are what will allow you to plan for a better lifestyle in the future. After all, there is still a life to live after retirement. In fact most consider it (and use it) as a perpetual vacation. Sounds great, but unfortunately, it costs money to travel the world on a perpetual vacation.
The power of compounding can further be seen in an anecdote discussed in a recent newsletter. “The classic example of the virtues of compounding returns goes back to 1626 when the Dutch purchased Manhattan Island from local American Indians for 60 guilders, or in excess of $25 at today’s exchange rates. The question debated by statisticians is this: who got the better deal…?” Had the 60 guilders been invested in stocks and bonds, “the $25 would now be worth $175 trillion, with which they could purchase not only all the real estate in New York City but all the real estate in the U.S.”*
In addition to compounding effects, it is important to stay consistent with your retirement savings. If money is ever tight, perhaps cut back on discretionary spending: eat out less, hold off on that new car, etc. so you can try to keep up with saving. Also, don’t forget that compounding works both ways: compounding interest on debt can be a good way to go broke. On the other hand, compounding returns on investments can be one of the best ways to increase wealth.
It’s time to put your future higher on the to-do list and raise the priority of your retirement savings!
*Source: Ned Davis Research Group, Ned’s Insights, April 13, 2015.
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