Friday, October 13, 2017

Finance Friday: The Time Value of Money

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.


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.


Lori Honeycutt said...

I love these posts! I find them to be incredibly helpful! I have retirement savings, and as I've said before I have one that I need to roll into someplace because it's literally just sitting there. I'm going to take the time to call and find out what I need to do. Michael actively watches his account so with that one I'm going to roll it over into his since he manages that. I have the account I created at Summit, which I don't contribute to but it's there and if I ever wanted to I could, that one is mine even though at one point Summit did contribute towards it as part of the company benefit. This current company I can go in and change what I'm saving at any time. I like that feature. This post reminded me that I need to change the amount I'm saving once the sale of the condo finalizes. Thank you for this!

Caroline said...

I need to read this post like 5 times. As a finance major who interned at Fidelity, I understand how important it is to start saving early and the time value of money.. I think where I get overwhelmed is where to put my money. It's so confusing! Luckily my Dad is helpful but I'd really like to be able to understand enough to do it on my own.

missris said...

This is so interesting! I love talking about all things personal finance :) Compound interest is so impactful! I'm thankful that when I started working for the State of Texas at the tender age of 22 they had an opt-out retirement plan (which of course I didn't know how to opt out of) so I started saving for retirement super young. I would love to retire early, or at least have that option should I want to take it.

Jolene - EverydayFoodie said...

I absolutely LOVE this kind of stuff. I am one of those weird people who enjoys doing taxes, etc., so perhaps I would have enjoyed accounting, or a different job in finance.

Both Christopher and I fortunately don't have to worry too much about saving for the bulk of our retirement, as both our jobs have pension plans that we cannot opt out of (not that we would opt out), so we never see the money, as it's an automatic deduction from our check that we don't have access to until retirement. His will be a lump sum amount when he retires, but FedEx has restrictions on how it is drawn, so that it will last. Mine is defined benefit, so I will just get a check every month for the rest of my life once I retire. We do choose to put into RRSPs too, just for extra, but that amount varies based on what we can afford.

I think one of the most important elements to being able to retire is being debt free. If we are debt free in retirement, then our pensions will be more than enough to live off of and maintain our lifestyle. Being debt free requires making the types of choices that a lot of people aren't willing to make (not continuously moving up and up into different homes, not spending $40,000 on a vehicle, not buying a lot of items we really don't need, etc.) ... basically living below our means. I think it's a really tough thing for people to even live within their means, let alone below their means.

katielookingforward said...

I like this stuff, but it also makes me wondering if I'm doing enough. I'm fairly certain I am middle of the pack at this point, but I could probably do better.

Gracie said...

I spent my early twenties in constant anxiety over my non-existent retirement. But I was living hand-to-mouth in pharmacy school, and I couldn't afford to save anything (it's HARD to work your way through professional school!). Thankfully, we are in a position now to pretty much make that up, but knowing how much potential interest I was wasting was killing me!
I did, however, have a series of short-term CDs: basically opened to mature right about the time I would need to pay tuition, so it was accessible for a big bill while still earning better interest than savings. It was the best I could do!

Last comment...a few years ago I talked to a pharmacist who confided that she was not in our company's profit sharing plan, and not only that, her direct deposit went into her checking because...that's the only account she had. She had been a pharmacist for three years at the time, and had earned absolutely zero interest on her money.

Stephany said...

I love this! I want more posts like this, but I also understand that they are so much work to put together. I haven't been saving for retirement, mostly because it wasn't possible with my first job (I started at $25,000 a year, lolololol, so I was barely breaking even each month). And I just never got started with my job now because I've been more focused on my student loans. But I feel really anxious about the thought of not having retirement savings and with a recent raise I got at work, I finally feel like I can give up some money in my paycheck for my 401k. Now to get over my embarrassment at being at my job for 4 years and not taking advantage of the 401k program... eeks.

Kyria @ Travel Spot said...

As you know, I love these posts. The graph makes it very clear that the long term is much more desirable. I like seeing that my 10 year investment would only get me about 12k, whereas, you don't just multiply that by three to get your 30 year number; it really is a huge difference. Another thing, which you probably covered in the retirement one but I can't remember, is that oftentimes your employer matches a certain amount and it's like refusing free money to not get the employer match. I know a lot of people think they don't make enough, or can't save right now etc...but I think that with a few deliberate life choices, everyone can put in at least a little bit, even if it's $5!! That $5 will still get compounded interest!!

I think the thing that is often hard for people, especially younger ones who are invested in equities, is seeing their account drop a lot from time to time. That is maybe something you can do a post on, how it pays to wait oftentimes, especially if they are younger, and how the markets go in cycles etc.

Marlys Dotzenrod said...

Greata advice and I highly recommend a financial advisor. He has helped us so much over the years as investing isn't our forte! With employees and having a matching fund, it is frustrating to encourage them to save for their retirement as they would rather spend that money now. And some think that paying off their low interest mortgages at a rapid rate is better than saving for retirement, which I disagree with.
It is hard to reason with people about this issure, but when they are now in their late 40's or early 50's and just putting the bare minimum away is not a smart plan.
Keep up these posts!

Amber said...

I really enjoy these posts! I would agree with Caroline that the part I find the most stressful is figuring out WHAT to invest in. I do tend to be a less risky person but I totally understand the benefit of more risky investments, especially since I'm so young and plan to have that money locked in for a long time. I too would like to retire in my early 60's. And now we have saving for our child to factor in as I would like to be able to help my child / children with university, their first down payment on a house etc. as my parents helped me. Anyways, I think this post was a VERY important reminder that the earlier you start saving / investing the better off you will be when you make it to retirement, something most of us 'know' but also don't always put into action.

I would love to hear your thoughts on debt vs. saving. I know some 'finance experts' think you should try to pay down ALL debt and be debt free before focusing on savings and I'd be curious your thoughts on that! I'm sure paying down credit cards / lines of credits etc. make sense but what about things like low interest car payments or mortgages?

Lauren @ Sassy Molassy said...

This is all very interesting and makes me excited to be working full time again (hopefully soon) and start to invest in my retirement again. It does make you think "How much do you really want x, y or z?" if those types of purchases set you back from retirement several years.

Sandra Bond said...

I love these posts, too, and hope you'll be posting more finance posts (especially because you're an expert and have some solid advice).

I have been contributing to retirement, but wish I could do more. Investing is a scary topic (J gets really anxious), but I know that we should invest some of our savings for the long term. I think getting a financial advisor involved is a good idea.
Do you recommend bank advisors or independent ones?