We will all come to that point in our lives when we stop working for a living, and need to rely on whatever sources of income remain. Those sources could be savings, interest, Social Security, even rents from properties purchased earlier.
As the cost of living increases, so will the amount we will need to continue our accustomed standard of living when retirement rolls around. We can start early and build savings, but it is the compounding effect of interest that will expand our total savings far above the amount we set aside.
Compounding is the process whereby interest is credited to an existing principal amount as well as to the interest already paid. The result–earned interest on the principle, plus interest on the interest–is often referred to as the “miracle of compounding.”
Setting Your Retirement Goal
Experts recommend that your annual retirement income goal should be about 80 percent of your final pre-retirement annual income. In other words, if you make $100,000 a year before retirement, after retirement, you will need $80,000 a year to live the lifestyle you are accustomed to.
Social Security was designed to cover roughly 40 percent of the annual retirement income requirement, but your Social Security check will depend upon how much you have paid in over your career. Benefits are calculated based on the highest earning 35 years of your working life. Online Social Security benefits estimators can give you an approximation of how much you might expect when you reach retirement age.
Online calculators such as the MaxiFi Planner can help you plan your own retirement financial scenario. These calculators frequently use common formulas such as the 4 percent rule, a way of calculating how much you’ll need in retirement. Simply divide your target annual retirement income by 4 percent. To reach that $80,000, for example, divide $80,000 by 4 percent. The resulting number is your goal: a $2 million retirement nest egg. By the 4 percent rule, that $2 million should last you about 30 years.
While investment returns vary considerably over time, the underlying assumption here is that you will make a 5 percent average annual return on your investments.
The $2 million doesn’t include the Social Security benefits that you will receive, and it also assumes you will live for about another 30 years after retirement. A longer life, expensive medical care, and other unknowns can change all this, but for planning purposes, this approach is reasonable.
Tracking Your Retirement Progress
Experts recommend that you save at least 20 percent of your income each year, but 25 percent is preferable, giving you a larger safety margin. Another way to see if you’re getting where you need to go, is to look at your current savings based on your age:
- Age 35—two times annual salary
- Age 40—three times annual salary
- Age 45—four times annual salary
- Age 50—five times annual salary
- Age 55—six times annual salary
- Age 60—seven times annual salary
- Age 65—eight times annual salary
All of these are general formulas that will get you close to your retirement goal of continuing your pre-retirement lifestyle.
From a Penny to $5 Million
The amazing math of compounding can be demonstrated by an example. If you start with a penny, double it the next day, double the higher amount the following day, and continue this pattern for 30 days, you will end up with well over $5 million!
The Rule of 72
The rule of 72 is a handy formula to calculate how long it will take to double your savings, given a fixed annual rate of return. Divide 72 by your investment’s interest rate: in our example of 5 percent per year investment return, it will take 72 divided by 5–or 14.4 years–to double the initial amount. Taking an extreme case of only 1 percent– more than most savings accounts pay in interest today–it would take 72 years to double your initial savings.
Let’s take one more look at the result of a $1,000 initial investment. As you can see in the chart below, two factors drive the magnitude of the investment growth. The first is time and the second is investment return. Note that while 5 percent investment returns may be achievable, 10 percent consistent average annual returns will require considerable investment skill–and a fair amount of good fortune.
Raiding Your 401(k)
In addition to the Social Security that will help support your annual expenses, it’s wise to take full advantage of your employer’s 401(k) match, by electing to deduct the maximum amount your company will match.
No matter how tempted you may be to withdraw some of your retirement savings, or borrow against your 401(k), resist that temptation with all your might. If you borrow against your 401(k), you will need to repay the amount borrowed, including interest. You may argue that you are simply repaying yourself, but the interruption of that compounding effect will diminish your overall total amount at the time you finally retire.
Most Americans don’t begin to provide for retirement at the start of their working life. There are many reasons for this, including student loans and low paying initial jobs. It is a challenge to save at a young age, especially to save 20 to 25 percent of income. In addition, the long-time horizon until retirement lulls us into a false sense of security. We think we will have plenty of time to figure out our retirement later in life.
However, the sooner you start saving, the less you will need to set aside over the rest of your life. The miracle of compounding takes over. Your nest egg begins to grow. You will be able to look forward to a comfortable retirement, rather than going into your autumn years with financial fear, topping everything else that comes with growing older.
The $2 million hypothetical retirement target won’t result from your earnings alone. It may also come from investment returns, compounding, and employer 401(k) match amounts over your working lifetime. There will be other sources, from Social Security to sales of assets you have accumulated throughout your life. Though $2 million seems like a daunting number, following the plan outlined here can lead to a pleasant surprise. It’s easy to attain your dream if you plan—and get started—NOW!
The Epoch Times Copyright © 2022 The views and opinions expressed are only those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.