Save Early & Automatically for Retirement.
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Retirement Preparation: 6 Reasons Saving Early and Automatically is the Difference Between Success & Failure
In retirement preparation time is a critical ingredient. The more years ahead of your retirement day you start, the easier it will be to accumulate savings. And the likelihood you will reach your goal for a secure retirement is much higher.
The best timing is to begin saving for retirement with your first full-time job.
Of course there are many urgent reasons to wait, like student loans, saving to move out, saving for a house, saving for your wedding, or buying a car.
But there is one really good reason to start early. In your 20s you will have a tremendous edge you’ll never have again: a full 40+ years to contribute and make your money go to work for you.
Also, with the first dollar you contribute, you’ll earn the peace of mind that you’re proactively preparing for retirement.
If you haven’t started yet it’s hard to explain, but beginning to save for the secure retirement you deserve will immediately and forever change the way you look at your finances in many positive and proactive ways.
And because you’re young, you won’t become discouraged by the low balances of the early years.
If you were instead to start in your mid 30s or later, during those first years, when your balances are modest, you might understandably feel that you have no chance of ever getting there.
Which is unfortunate because the more motivated you are, the more likely it is that you’ll stick with your plan for the long term.
Now if you’re past your 20s, and haven’t started yet, don’t despair.
It’s never too late to start saving. Regardless of how close you are to retirement, starting now is always better than not starting at all.
Whatever your age, and wherever you are today in your retirement preparation, the sooner you start, the more you benefit from what we call the Big 6:
- You unleash the massive power of compound interest
- You gain the reward of watching your savings grow
- You get free money from your employer
- You benefit from tax savings leverage
- You become an investor.
- Automation makes saving a good habit.
YOU UNLEASH THE MASSIVE POWER OF COMPOUND INTEREST
Compound interest allows your money to work for you 24/7. It has incredible power, but one of its key ingredients is time: with too little time its awesome power can be reduced to a mere whimper.
When compound interest has a multi-decade horizon to work for you it will unleash massive results. This is especially true in the later years when balances are larger, and it works to double and then redouble those large amounts.
The most compelling example of the power of doubling is an old riddle about a boy who was hired by a shopkeeper who asked him what he wanted as a starting wage.
The boy said “Pay me a penny on my first day and double it every day until the end of the month, and I’ll be very happy.”
This sounds like a foolish and meager request, to the shopkeeper’s great advantage, but if you assume 30 days in the month, and that the boy works seven days a week, his salary on day 30 is $5,368,709.12!
Of course it’s nearly impossible your retirement funds will double your initial investment 30 times over, but each doubling adds significantly to your wealth.
With just a 7.2% rate of return, you’ll double your initial investment every 10 years. If you start too late you’ll miss out on the power of doubling and redoubling your contributions.
For example, if you’re 25 and have a nest egg of $35,000 in a tax free retirement account, even if you don’t add one penny, at 7.2% return, it will grow to an unbelievable $560,000 by age 65. But if you don’t have the sum until 45, it grows to only $140,000, which is over two thirds less.
Compound interest is indeed a tremendous retirement planning force.
YOU GAIN THE REWARD OF WATCHING YOUR SAVINGS GROW
Think about the last time you started a new habit like exercising more, cutting calories, or spending less time checking your phone.
It wasn’t easy, especially at the start.
The hardest part is the early days, when you’re sticking with the new program but not yet seeing big results. Saving for retirement poses the same challenge.
This can be especially true when you’re young and your salary may be comparatively low versus where it will be in a decade.
For example, if you start with your first job out of college, at age 22, a 3% 401K contribution may be about $75 a month. Even with employer match, after 6 months you may have in the range of $900 saved. Not bad, until you read the article that says you’ll need $2,000,000 for retirement.
It almost makes you want to quit and just spend the $900 on fun times.
But gradually you increase your contribution to 5% per year, add in the growth you’ll get from investing, more employer match, and more of your dollars as you receive raises. By age 27 your retirement account starts to get impressive for someone who’s so young.
That’s when you’ll truly grow excited as you see ‘real money’ in your 401k. Real numbers help make the benefits more tangible.
Here’s an example that uses $30,000 as a starting annual salary, assumes 4% annual salary increases, ramps from 3% to 5% annual contributions in 0.5% increments, uses 100% employer match up to 5%, and an annual investment return of roughly 7%. These numbers are just for illustration, but not far from reality for many:
To highlight two key numbers: you contributed a total of $8,388 over six years and, due to employer match and investment gains, at the end of age 27, you now have $20,131, or 140% more than you contributed.
If all young careerists had the opportunity to see the above analysis, many more would immediately enroll.
While the earlier years are the toughest time to save for your future, setting aside a mere $75 in pretax income per month to start will hardly be missed, but will powerfully launch you on your way to a secure retirement.
YOU GET FREE MONEY FROM YOUR EMPLOYER
If you are eligible, the matching funds from your employer is ‘free’ money in three ways.
First, it’s like getting a cash bonus that you don’t have to hit any goals to receive.
You contribute, they match, even if you didn’t have the greatest performance review, or if they aren’t giving out any raises for the year.
Second, depending on your total tax bracket (federal, state, local), the amount of the match is much larger than it looks because it’s tax free.
Every dollar of match can be the equivalent of getting $1.43 or $1.67 in bonus pay that would have been taxed.
For example, let’s say your salary is $60,000, and your employer matches the first 6% of your contributions, which is $3600.
If your total tax burden is 30%, the $3600 match is equivalent to $5143. The higher your tax bracket, the more powerful the match.
The final huge benefit is that the match will go on to grow and compound tax-free, all the way until retirement. Your free money will make you more free money.
How can you beat that? Passing on this free money is a huge mistake that can compromise a secure retirement. Don’t leave money on the table!
YOU BENEFIT FROM TAX SAVINGS LEVERAGE
We’ve already shown how powerful tax free contributions are, but what’s even more magical is that your contributions are also likely pre-tax. This creates what could be considered a form of financial leverage.
One example of leverage created by credit is buying a rental property with a small amount down. If your income producing property that costs $100,000 can be acquired with $5,000 down, you create $95,000 (or 19X) in leverage because you’re controlling a $100,000 asset for $5,000 out of pocket.
With tax advantaged accounts like 401Ks, where your contributions are made with pre-tax dollars, you are also creating a form of leverage.
For every dollar you contribute, you’re only missing out on $0.60 or $0.70 of take home pay.
This creates leverage because you are receiving $1 of benefit, yet you sacrifice far less than a dollar of take home pay.
Ideally the tax advantages will motivate you to contribute more, and then what you contribute compounds every year with no taxes.
You’ll only pay taxes when you withdraw the funds and, for most, it will be at a lower tax rate in retirement.
YOU BECOME AN INVESTOR
By opening and managing a retirement account you become an active investor with a portfolio.
If you haven’t taken the investing plunge yet, the benefits are that it requires you to make investment decisions, and exposes you to retirement savings tools that help you determine how much you need to fund your secure retirement.
In our post Great Recession world many are understandably reluctant to take the plunge into stocks and other investments that might lose principal. This is particularly the case for younger investors.
A Goldman Sachs research survey showed that Millennials are deeply mistrustful of the stock market. In fact, only 18% of Millennials trusted the stock market as “the best way to save for the future.”
Starting a retirement account, and investing in stocks, will increase your expertise and confidence in the markets.
While markets will fluctuate, it’s highly likely that it’s still the best place, over a long horizon, to earn strong returns.
One of the biggest challenges for first-time 401k participants is the sometimes dizzying array of investment options. It’s important to avoid unnecessary complexity in building your investment mix.
The use of stock research and selection tools can often be useful in narrowing the options to those best suited for your needs.
Also, in order to simplify investment selection, most administrators now offer what are called target date funds.
You simply pick the fund that has the date that’s closest to your projected year of retirement. That fund will be structured with an investment mix that represents a level of risk believed to be optimal given the time you have ahead of retirement.
The closer you are to retirement, typically the less risk you will be exposed to.
While target date funds are not perfect, they are often a reasonable default choice, especially if investment selection paralysis is the main reason for not starting a retirement savings account.
Before committing to a target date fund, however, check to make sure that the annual load or fee is 0.50% or lower (ideally 0.25%).
Another feature some administrators offer is help in managing your investment choices. Some will charge a small annual load or fee (ideally 0.50% or less) for live assistance to help you build a mix of investments based on your targeted retirement date, growth objectives, and risk tolerance.
Beyond investment selection, most 401k administrators provide free online tools to help you better prepare for retirement. You can build financial models and play out a range of “what ifs” with interest rates, inflation, annual contributions, retirement age, and other key drivers.
Using these models gives you a better understanding of the mechanics behind key assumptions and compound interest, and you can get a feel for how you can influence your readiness for retirement.
If unexpected events occur, these tools allow you to be agile in making the necessary adjustments to get back on track.
AUTOMATION MAKES SAVING A GOOD HABIT
One of the strongest benefits of an employer-sponsored retirement savings plan, like a 401k, is that the cash is taken out of your pay automatically. This helps saving become an ingrained habit.
Changes in our behavior are typically difficult to make.
If the change requires us to sacrifice something, it can be even more challenging. Saving money for a far-off future event is the definition of delayed gratification itself, and that simply doesn’t sound exciting.
If we have to make our savings decisions with every paycheck, after we have our take-home pay in hand, it becomes too easy to say “I know I need to save, but I’ll start next week.”
Then, despite our best intentions, pressing needs, realities, the marketing messages scream SPEND IT NOW and human nature agrees!
After all, we worked hard. We deserve it. Our friends are doing it. Our kids need it. Life is short.
These factors all pull us toward opening our wallet and putting our worries for the future on hold until some later date. But as we saw with compound interest, that lost time has an incredibly high cost.
Automatic savings plans eliminate the risk that comes from having to make the save/don’t save decision every payday.
With your employer withholding your money automatically, the savings habit becomes easier. And sure, you can always sign into your 401k online portal to turn it off, but usually it’s too much of a hassle to bother.
In fact, as the positive results grow, the savings habit will no longer be a sacrifice, but instead becomes a source of joy and peace of mind.
Many set their budgets and spending levels based on take-home pay because it represents cash they have available to spend.
But when your employer deducts your retirement savings before you receive your paycheck, it’s almost like the cash going into your retirement account never existed. And that’s a good thing.
When you go to set your annual spending budget, the pre-tax money flowing into your retirement account is invisible, because it never was part of your spending base.
Ultimately, with payroll deduction, you learn to live without the cash that’s being routed to your retirement savings, and therefore you’re not tempted to spend it.
Either immediately or eventually, you don’t miss it and so retirement saving doesn’t ‘hurt’ as much as savings decisions you make from your take-home pay.
The Bottom Line
After you Control Your Burn Rate & Debt, it’s clear that Saving Early & Automatically is the second most important step you can take to ensure the secure retirement you deserve.
This step places the power of time, compound interest, and positive savings habits on your side. These three forces are among the most proven and powerful in the universe of retirement preparation!