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Whenever you read articles about investing for retirement, they always say you should save 10% of your gross income. In the Financial Independence Retire Early groups you see people saving 40% - 70% of their gross incomes. But what should you do if you’re first starting out? What should you do if you have never invested in a 401k or other company retirement plan? What if you’re late to the game or you are behind on your savings because life got in the way? Is there hope? Yes, I believe there is and I’m going to share a couple of ideas with you.
Let’s Break This Down
I’m going to use 401k as a catch all for any type of company sponsored retirement plan. I know there is an alphabet soup of company sponsored plans, Simple IRA, SEP, Profit Sharing Plan, Cash Balance plan, etc., but for simplicity I am going to say 401k when I am talking about an employer sponsored plan.
Ok, you have your 401k meeting and you have always heard about these things and you know you should save money, but what is the best thing to do. First, there is no best thing or only thing or thing your rich Uncle Larry said, that has to apply to you. I’m going to give a suggestion, but there is no one way to do anything. Here’s what I think would be a good way to start.
Step 1: Find out if your company will match what you contribute to the plan. Many plans have a matching formula. Some will say, we will match dollar for dollar of the first 3% you contribute to the plan. Others will have something like, we match 50% up to 6% of contributions. Some plans have a matching formula that says they will match dollar for dollar up to 3% and 50% of the next 2% that you contribute. In other words, if you invest 5% of your salary, they will match 4%. It doesn’t really matter what the formula is, the key is for you to understand it.
Next, try to contribute such that you get the maximum match from the company. If they match dollar for dollar of the first 3%, then start contributing 3%. If they match 50% of the first 6%, contribute the 6%. Whatever they are willing to match, you should be willing to contribute because that is free money. Who doesn’t like free?
What happens if you multiply 6% times your paycheck and it’s more than you can handle? Should I just not invest? NO!!! Multiply the number, in this case, .06 times your gross paycheck. See what the real dollar amount is before you think you can’t do this. The reason I am telling you to do this is, I think in percentages, but my lovely wife told me that not everybody thinks in percentages. So here’s an example. Let’s say you make $60,000 per year and you get paid every other week. Take $60,000 and divide it by 26. That number is $2307.69. Multiply that by .06 and you get, $138.46. 6% of $60,000 sounds like a lot, but $138.46 might be more palatable. But what if that is too much? Well, 5% is $115.38. 4% is $92.30. You get the point. Just pick some amount and start with that.
Step 2: Try to add 1% more each year. A lot of 401k platforms have a section in their website where you can add an additional amount of money each year up to a point where you choose to stop. For example, you start out at 3% in year one. You choose the option to add 1% more each year until you get to 15 or 20%.
I think saving money is a lot like working out. Nobody can run a marathon. The first dude that tried, died at the end of the 26.2 miles. Yet, you can probably walk around the block. Then you could walk around two blocks. Then you could walk a mile. After that you start to jog, maybe run a bit and eventually enter a local 5k. If you have the desire, with time and proper training, you could probably run a marathon.
Investing in your 401k can work out exactly the same way. Start with a number you can handle. Preferably one where you are getting the maximum match. It that is too much, at first, start with something smaller. Here is my last bit of advice for this situation. Usually, the 401k plan will have the option of investing a percentage of your salary or a dollar amount. I tell people to choose a percentage. I have seen too many times where a person chose a dollar amount, $100.00 per check for instance, and I go review their plan with them and 5 years later, they are still contributing $100.00 per check. Even if you never followed my 1% more advice, the dollar amount that you are contributing would probably increase because most people get some type of raise over those 5 years.
Step 3: Where should you invest? I’m going to do a little more HP12C math for you, then we can discuss this a little bit. In my example above with the $60,000 person, if they 6% of their salary and their employer matches 3%, they will be investing $5400.00 per year. That works out to $450.00 per month between their salary deferrals and their employer match.
People always want to know, where’s the best place to put my money? Here’s the time value of money math: $450.00 per month @7% interest for 5 years equals $32,404.74. If you do the same calculation but assume a 10% interest rate for the same 5 years, you get $35,137.07. If you get 4% interest for 5 years, you end up with $29,933.98. Did you notice something? At first, it really doesn’t matter which fund you decide to invest in. You could get to $35,137.07 in the 4% example by raising your monthly investment to $528.22.
In a short period of time like, 5 years, it really doesn’t make a tremendous difference where you invest your salary deferrals. In the longer term, this is not true at all. Using the same examples over 30 years and it turns out like this:
4%: $313,363.30
7%: $552,189.37
10%: $1,025,696.39
The point of this exercise isn’t to tell you where to invest your money, the point is, start saving some money. Pick a place to put it. Try to increase the amount you contribute a little bit each year. At first, your savings rate is much more important than your investment return. The earlier you start investing, the better it will be in the long term for you.
Late to the FIRE!
I’m going to keep this part a little bit short because, this piece is getting kind of long. I just saw an article from a guy named Scott Galloway titled, “How To Become Truly Rich”. In one of the charts it shows someone saving $12,000 per year at 7% for 40 years has 4.7 times more money that someone saving the same amount of money at the same interest rate for 20 years. The 40 year person has $2,563,319 and the poor 20 year guy has $526,382. Well, what if you don’t have 40 years left, what do you do??
In my fancy HP12C calculator, inputs for future value of money calculations are time (n), interest (i), present value (pv)(that’s what you have right now) and payment (pmt) (that’s how much you can add to it) = future value (fv). If you don’t have much time and you don’t have a big starting present value, you’ve got two inputs to work with, interest and payment.
The surprising thing is, payment or the amount you are willing to invest on a consistent basis is much more powerful than the interest rate you get when you are dealing with needing to accumulate money in a shorter period of time. Time for some more math!
Let’s say you’re 55 years old and you have $50,000 saved in your 401k plan. If you keep doing the save 6%, get the 3% match and retire at age 67 with what you have in your 401k plan plus Social Security, you might have to adjust your lifestyle a bit in the future.
$50,000 PV, $5400 PMT, 7% i, 12 n = $215,969
You’ll get approximately, $2113.00 per month from Social Security and using the 4% Rule, you can take about $720.00 per month off of your 401k. So, your monthly income would be a little more than $2800.00 per month. Quite a drop from the $5000.00 per month you were grossing while you were working.
The S&P 500 index has averaged 10.9% over the past 30 years. What happens if we change our interest rate from 7% to 10.9% over these same 12 years?
$50,000PV, $5400 PMT, 10.9% i, 12 n = $308,241
Granted, $308,000 is more than $215,000, but you have to increase your rate of return by over 55% to get there. For a lot of people age 55 and over, having their 401k invested solely in the stock market might be more volatility than they are willing to take on. Here’s another idea that might help.
Instead of retiring at age 67, wait until you are 70 years old. Also, increase the amount you are investing in your 401k from 6% to 10%. Here’s what your situation would look like without taking on any more stock market volatility.
Social Security benefit at age 70: $2640.00 per month
Value of your 401k: $379,944 X .04 = $15,197 or $1266.48 per month.
Your total income at this point $3906.00 per month.
In this example, you increased your contribution by $150.00 per month, worked for an extra three years and increased your monthly retirement income by over $1100.00!
These are just a couple of ideas! Everybody’s situation is different. I’m just trying to show the power of time (n) and contribution (pmt), even if you are behind in your planning. You don’t really have to take on additional volatility in order to achieve some reasonable results.
A Little Bit More
In figuring out the future value somebody is going to have, the inputs are basically, what you have now, what you’re willing to invest on a regular basis, the amount of time you have to invest and the rate of return you can get. The one input you can control is the amount you are willing to save or invest. The amount of money you have, is the amount you have. Too many people beat themselves up about not starting earlier or other mistakes in hindsight that are easy to see. But the thing is, you can’t do anything to change the past.
In addition, while you can invest in areas that have more opportunity, for instance, the S&P 500 fund versus the money market account, you still don’t have any control over the return. Finally, when you are younger, time is your friend. When you are more experienced, time is your enemy. In either case, increasing the amount you can invest will have a huge impact on the amount of money you have in the future!
Thanks for taking your time to read this. There is so much more to explore, but I hope this helps a bit. Feel free to reach out to me if you have any questions. As always, thanks for reading! KB