March 18, 2015

How saving 1% of your income can make you a one percenter

Gotta love it! Source: MarketWatch

"When it comes to saving for retirement, what difference can another 1% of your pay make?Plenty.
Thanks to the magic of compounding, “a little bit (of extra savings) today can go a long way tomorrow” in terms of the retirement income it’ll generate, says Fidelity Investments, which crunched the numbers for a report released this week."
If you'll remember, I spent a lot of time explaining how compounding interest works, I even have a youtube video out on it, somewhere!

According to Fidelity’s calculations, a 25-year-old with a $40,000 salary must set aside an additional $33 a month to save an extra 1% annually. But that little bit of extra savings will translate into an additional $320 of monthly income (in today’s dollars) over a 25-year retirement. (This assumes our 25-year-old earns a 1.5% annual raise, net of inflation, works until he is 67, and invests his savings in assets that earn a 7% annual return.)
This actually scary, because at the time of writing, I am 25 years old! An additional $320 of monthly Income, compounded back into my investment, would earn me $973,986.33 by the time I am age 67. That number is definitely nothing to balk at, but exactly how many 25 year-olds' do we know socking away an additional $320 a month instead of investing it for the long term?

Of course, the benefits are less dramatic for those with shorter time horizons. But that doesn’t mean the strategy isn’t worthwhile.
The journey of a thousand miles begins with a single step. If you need to pay yourself in retirement, you need to build your retirement account like the house from the fairy-tale regarding the 3 little pigs.

Let's look at the numbers if I were to wait 10, 20, or 30 years to start saving:

According to Fidelity:
  • A 35-year-old with a $60,000 salary who saves an extra 1% annually must save $50 more a month now, but will receive an additional $270 of monthly retirement income in today’s dollars.
  • A 45-year-old with a $70,000 salary who saves an extra 1% annually must save $58 more a month now, but will receive an additional $160 of monthly retirement income in today’s dollars.
  • A 55-year-old with an $80,000 salary who saves an extra 1% annually must save $67 more a month now, but will receive an additional $70 of monthly retirement income in today’s dollars.
So, after I run some calculations:

  • A 35-year-old re-investing 1% of savings will have $385,670.98 by the time age 67 is reached.
  • A 45-year-old? Assuming the exact same parameters will have $99,943.30 by the age of 67.
  • Finally, a 55-year-old using the numbers provided by Fidelity will gain $15,728.65 by retirement (age 67)

The message: Small steps can have big consequences when it comes to retirement.
“When you ask people, ‘Can you save more?’ many people think, ‘I can’t,’” says Jeanne Thompson, a vice president at Fidelity. That’s because they “assume that they have to save so much more and a little bit isn’t going to make a difference.” But the key insight, she adds, is that “little incremental differences can make a huge difference over time.”
Which, even if my calculations are wrong, the power of compounding interest by starting sooner means a difference of $588,315 in earnings for that nest egg of yours. Which is money working for you while you sleep.

According to Fidelity, many people underestimate the impact saving 1% more can make. When asked how much an extra $50 a month would amount to over a 25-year period, the median response was $17,000—or less than half the $44,000 value Fidelity projects.
Fidelity recommends putting away 10% to 15% of annual pretax pay for retirement, including matching contributions from an employer. “But if you don’t save this much from the get-go,” don’t despair, the company says. “Start by saving up to the company match,” says Thompson and then increase your savings rate by 1% every year until you hit the 10% to 15% target.
More potentially good news: When told the benefit of saving 1% more, almost 90% of the 1,039 people who responded to a poll Fidelity conducted said it would either be an “extremely easy” or “easy” thing to accomplish.
As the economy improved, 22% of Fidelity’s 401(k) investors actually increased their savings rate over the past year—by an average of 4 percentage points (that is, 4% of their pay)."

While I would always recommend to fund your retirement with after-tax dollars, so that your bucks grow tax-free and can be accessed, at retirement, without taxation, Fidelity argues some great points here. Start saving now. Increase your savings each year. Compounding interest is one of the greatest wonders of the [mathematical] world. Now you know how the 1% became the one percent, they just invested 1%!