When I wrote my first "Finance Friday"
post back in April, I did not intend to go 6 months before writing another post in this series. But life happens. These posts take some time, and in this case, math, to write so I kept putting it off! But today I'm ready to share my next post in the series.
In my last post, I talked about the importance of saving for retirement. As I said in that post, I place an incredibly low probability on the existence of the social security program by the time I retire. I'm a risk averse individual so I do not like to assume that social security will be around, or that it will be provide a sufficient amount of monthly income if that program is still in existence. So Phil and I have really focused on saving for our own retirement so that we can afford to stop working, ideally in our early 60s.
In today's post, I want to talk about the time value of money - a phrase or concept that gets thrown around often but might not be something that everyone grasps or thinks about. This is purely a mathematical concept. In simple terms, it is talking about the fact that the longer you save and the more you save, the larger the pile of money is going to be when you want to retire and live off of your retirement accounts.
Before I delve into the math, I want to address the fact that there is a certain level of privilege associated with saving for retirement. To be able to save for retirement, you need to be able to live within your means, provide for your family, and have money left over, after all your bills have been paid, to put money aside in savings or a retirement account. I completely recognize that this is not possible for everyone.
That said, I think we live in a culture of entitlement, and a culture of "keeping up with the Jones's." Saving for retirement requires sacrifices. We have to say no to some of our current wants and desires in order to be able to stop working at some point in the future. That's not always easy, especially if you are struggling to make ends meet with your household income. This reality has been brought even more to light recently as we start to look at daycare options and have had to come to terms with the fact that we'll spend over $18,000 for daycare in the first year of our child's life. Each year of our life requires evaluation about what our savings goals are and how we are going to achieve them as our expenses fluctuate. I also recognize that there is a certain level of privilege associated with being able to save for retirement - I understand that many people in our country are living paycheck to paycheck and don't have excess money at the end of the month to put in savings or towards retirement.
I bring all of this up as a precursor of getting into the time value of money because saving has to be so intentional. I'm going to share the math behind the time value of money, but the first decision we all have to make is how we are going to go about finding the money to save each month or year. It requires discipline and for most of us, it requires automation. All of my savings occur before the money hits my bank account. My 401k contribution gets deducted from each paycheck, and a certain amount of my take home pay gets automatically transferred to a savings account that I can not easily access. I use that savings account to fund my IRA contribution each year. Granted, not everyone needs their savings to be this automated. For example, Phil does not have money automatically transferred to a savings account. Instead he transfers money to savings once he reaches a certain dollar level in his checking account. That could work for me, but I'd prefer if the money just automatically goes to savings without me seeing it in our checking account.
Now - let's get into the math behind the time value of money. I'm going to share 2 examples of the math behind the time value of money - meaning the power of your money to earn interest each month or year and how it will multiply and grow exponentially with time. In these calculations, I made the assumption that your money will earn 4% per year. That might
be an over-optimistic assumption but it's a common estimate used by
financial planners. One point worth mentioning - you can not earn 4% per
year in a savings account. You would need to invest it in a mutual fund or some sort with exposure to equity markets. Having money in a savings account is fine and important - but that is not where you should be saving money you intend to use for retirement, for a variety of reasons.
Example #1: Saving $100/month. In the first example we'll look at what happens if you save $100/month for 10, 20 or 30 years. The time value of money calculation is powerful to look at in graphical form because it illustrates the fact that the sooner you start saving, the better. In this scenario, let's pretend you are 30 years old and want to retire when you are 60 (which might not be realistic - this is merely meant to be illustrative) and will either start saving $100/month in a retirement account this year, when you turn 40 or when you turn 50.
As this graph clearly illustrates - the longer you save, the more money you will have when you are 60 years old. Let's use the 30 year investment period to illustrate the time value of money, and the power of compounding of interest/dividends (i.e. interest earned on interest). In this example, contributing $100/month for 30 years will grow to a total of about $69,500 in 30 years. If, instead, you put $100 per month under your mattress for 30 years, it would total $36,000 in 30 years ($100 x 12 x 30). So you'd be missing out on about
$33,500 in compounding interest/dividends if you didn't invest the money in a mutual fund or some other financial product.
Example #2: Saving $5,000/year. In this example, we will look at what happens if you save $5,000/year for 10, 20, or 30 years. You can think of a 30 year old person who makes $50,000/year and puts 10% of their paycheck in their 401k, or about $192/paycheck if you are paid every other week, either at age 30, 40, or 50 and wants to retire at age 60.
Again, the graph shows that sooner you start investing, the larger that pile of money will be when you turn 60. In this case, the 30 year old who contributed $5,000 year for 30 years has put aside $150,000 dollars over 30 years, but it grows to about $290,000 in 30 years.
In closing, there are 3 ways that you can impact the size of an investment account at your retirement age:
1.
The amount you contribute. The more you are able to put away each month or year, the larger the amount in the retirement account will be when you retire.
2.
The length of time you save/contribute to the retirement account. As these graphs show, the earlier you start investing in your retirement account, the better.
3.
The return of the investment product. We can't control how certain areas of the financial market perform - they will fluctuate over time. But we can control what areas of the financial market we invest in. Let's use the example of investing $100/month for 30 years. If you would have put this in a savings account that earns 1%, in 30 years the account would grow to just under $42,000. Which sounds great until you compare that to the investment account earning 4%, which becomes $69,500 in 30 years. This illustrates why it is important to be thoughtful about how we invest our retirement savings. Picking the least risky investment might seem like a good idea, but you are likely missing out on returns that you could be earning. I'll talk more about this in a future post. I understand that it is VERY OVERWHELMING to look at your investment options in your 401k or IRA. But if it overwhelms you, instead of picking the least risky investment option, consider working with a financial advisor. They can asses your risk tolerances and make a recommendation. In general, the younger you are, the more heavily invested you should be in equity markets.
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Hopefully I haven't bored you all to tears by this point! If you have any questions, please let me know as I am always happy to talk about all things finance. You can always leave a comment (make sure it's linked to an email address so I can respond) or send me an email at lisasyarns at gmail dot com.
Are there any finance topics in particular that you'd like me to cover in future posts? I want these posts to be as useful as possible, so I welcome your feedback.
Disclaimer:
The thoughts in this post are my own thoughts and are not meant to be
taken as investment advice. I have no fiduciary responsibility to anyone
that reads this post. Additionally, my comments are US-centric; retirement benefits vary from country to country.
