Retirement -- Savings -- 401k -- Compounding Interest


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Retirement -- Savings -- 401k -- Compounding Interest

Retiring from your successful career is something you want to start planning right when you start your career fresh out of college. The earlier you start planning and contributing towards your retirement the easier it will be for you in the run. As a result, you will save significant amounts of money towards retirement.  Below are some examples and terminology to get a better understanding of how to prepare and plan for retirement. 


Retirement looms ahead of all recent college graduates.  Again and again, retirement is pushed at you, but when it seems so far away, why should you worry about it now?  The average college graduate, graduates at the age of twenty-five, forty years before most plan to retire.  Forty years is a long time – so why start thinking about saving for retirement now?  Take for example the following scenario:


A young recent college graduate, age twenty-five, finds his first employment after college.  Although he may only be eligible for an entry-level position with a company, he sees the opportunities for promotions and upgrades down the road.  Ultimately, this job will be worth it in the long run.  The company offers him a reasonable salary, but not anything to brag about.  A retirement consultant approaches him and talks with him about pulling money out of his check every month to send to his retirement fund.  With student loans now due and other traditional expenses, he opts out of retirement for the time being.  He reasons that paying off his student loans will help to save him more money in the long run, allowing him to start contributing to his retirement in five or ten years.  This will still leave him at least thirty years to save for retirement.


This has become an all to familiar scenario for recent college graduates.  You will find yourself giving excuses – some of them very valid excuses – to wait to save until situations improve.   So then, what is wrong with having this kind of attitude?


Every retiree has a number goal – an amount of money they hope to have saved when they retire.  This number can be generated using a couple different methods, but ultimately, think of setting your own goal based on the following statement.  At the time of retirement, you should not have a reduction in your quality of life.  Here’s a little more insight into this idea.


The last few years of working, you will get used to a certain quality of living.  The salary you are awarded from your job defines that standard.  This quality of living will include things like cars, homes, vacations, monthly spending money (i.e. play money), etc.  After retirement, your salary no longer comes each month, so where is your living allowance?  Retirement.  Whatever retirement money you have currently saved, will determine if your quality of life can stay the same.  During retirement are your house and car payments still affordable, or are they too expensive for the monthly budget?  If every year, you and your spouse plan a certain vacation, does it still fit in the budget?  Is the monthly play money you used to allow yourself staying the same, allowing for movies, extra shopping trips, mini-getaways, etc.?


Ultimately, your goal should be that the lifestyle being led at sixty or sixty-five pre-retirement should be the same lifestyle continued after retirement.  If quality or standard of living must change, then there was failure to save the appropriate amount of money.


This doesn’t necessarily mean that you’ll need to receive the same paycheck during retirement that you received your final years working, in fact for most people it is less, but that doesn’t mean the quality of life changes for them.  They can still live in their current home, but consider that perhaps it is paid off.  The same could apply for cars.  But perhaps the most important thing to consider in your monthly budget is that you’ll no longer need to contribute any money into your retirement, since you are living it!


For most people, the closer they get to retirement, the more they invest in their retirement accounts.  As we get older, our lives tend to become simpler rather than more complicated.  Things like children and all their related expenses tend to be removed from the budget.  Perhaps you are able to pay off your home, cars, and other toys that you had monthly payments on previously.  Thus, there tends to be a surplus in your income, and most people, as they are anticipating retirement, contribute that surplus into those accounts.


So then when retirement rolls around, you find yourself not needing nearly the same amount of money you needed before retirement.  Let’s take for example the following couple:


Jared and Danielle make a combined monthly income of $10,000.  They are 64 years old and planning to retire at 65.  Here is a list of their monthly expenses:

  1. House Payment – $3,000
  2. Utilities – $250
  3. Car Payment #1 – $300
  4. Car Payment #2 – $300
  5. Boat Payment – $250
  6. Groceries – $400
  7. Date Money – $200
  8. Personal Money – $300
  9. Other – $500
  10. Savings  – $1,000
  11. Retirement – $3,500

Now let’s say that everything in this budget is to stay exactly the same when Jared and Danielle retire – except their retirement contribution.  If everything were to stay the same, including putting away $1,000 each month into savings, Jared and Danielle can live comfortably on 65% of their pre-retirement monthly income now that they no longer need to save any more for retirement.


Perhaps it is hard to think now, in your twenties, what type of lifestyle you will have when you are in your sixties, but thinking about basic needs and what you spend your money on now will essentially be the same.  You will still have a rent/mortgage payment to take care of your housing.  You’ll still need to eat, so you’ll have a grocery budget, you’ll probably have a car or two, perhaps a toy like a boat or RV, etc.  The difference between your budget now and your budget in the future is that you will have more money to spend on things in the future.  However, the things you enjoy now probably won’t change.  If you love movies, you will still go to the movie, but whereas now you only go on opening night every once in a while because you don’t like to shell out the money for a first-run movie, in the future you won’t mind spending the extra money to see a movie during opening weekend or before it hits dollar theaters.  Essentially you’ll end up spending your money on the same things just in larger quantities.  Of course that’s not to say you won’t pick up other hobbies as you get older, golfing for example.  And we all know that golfing isn’t a cheap sport, so you’ll make room in your budget to include golfing.  This may mean you don’t go to movie as often or you don’t have a boat payment.  Regardless, all of the principles still apply.


There are also online resources to help you determine the amount of annual money you’ll need at retirement.  By using percentages and general ideas about the US population, they can help you decide how much you will need at retirement.


It may seem overwhelming at first, but it doesn’t need to be.  There are some key things to understanding retirement.  Being knowledgeable and prepared at a young age will ultimately help you plan for retirement. Remember that you may not understand all of the parts about retirement that they ask you to know.  We will explain each of them throughout the book, so revisit this calculator after reading to give yourself a better and more accurate representation of how much you’ll need.


In the introduction, we looked at an example showing a typical college graduate faced with the decision to start saving for retirement now or put it off for a few years down the road.  Understanding the benefits of saving now, might sway his and your decision to start with the first paycheck.


The Benefits of Compounding Interest

Although there are many different retirement programs available (discussed individually in subsequent sections), the following example will help to illustrate a basic retirement saving principle.


Let’s take for example two employees at the same company.  George chooses to contribute $100 every month from his first paycheck, or $1200 a year.  He starts saving at the age of 25 and plans to retire at 65, thus giving him 40 years to contribute.  For the sake of the example, George is going to continue to only invest $100 a month for forty years.  Now, let’s look at a second employee, Jane, who chooses not to invest her money into retirement when she first starts working.  Unlike George, Jane waits five years, at age thirty to start saving.  She contributes the same amount, $100 each month, but now she only has 35 years instead of 40 to save her money.  What is the difference in their two lump sums at the age of 65?


George will have saved just over $310,000 while Jane will have only saved $206,000.  That five year’s difference cost Jane $100,000 in her retirement.  How does this happen?


Compounding Interest.  This is something you were probably taught in junior high or even elementary math, and had that thought, “When will I ever use this?” – well here is the real world application.

A little refresher on interest in general.  When you put money into any kind of a savings account, whether it is the traditional savings account at the bank, or a retirement savings account (401k, 403b, etc.), the institution or company you save with will give you an interest rate.    Interest is money that is paid to you at particular intervals based on a percentage.  It is sort of like a bank’s way of saying “thank you” for putting your money in their institution.


When it comes to interest rates, an account that allows you to put in and take out your money at any time will have a lower interest rate than an account that has limitations.  This is the case, because the savings institution where your money is placed can always count on your money to be there – therefore giving them the freedom to use it for other purposes.


For example, if you have a money market account that has a minimum balance of $5,000, then you’ve told the bank that at all times you will have at least $5,000 in that account.  They then, knowing that you will always have $5,000 in the bank, can give someone else a loan for $5,000.  When you decide to close your account, they will do the same for you, giving you back $5,000.  Because they can guarantee your money will be there, they reward you by giving you a higher interest rate.  Other accounts like CDs or Education Funds have a time limitation as well on them before you can touch the money.  Therefore, the bank knows that the money in those types of accounts won’t be accessed until a designated time.  These accounts also have higher interest rates.


There are two types of interest that you could see when saving your money, simple and compound.  Simple interest, is interest paid only on the principal amount; whereas, compounding interest pays interest based on the principal amount and the interest accrued.  Let’s better understand this idea with an example.


Let’s say you have $10,000 sitting in your bank account.  The bank tells you that they work on simple interest, paying you once a year.  The interest rate is 5%.


The formula for calculating what you will have in a year is:

Interest = Principal*(Rate)*(Number of times accumulated)

So in our case the equation would look like this:

?? = 10000*(.05)*(1) with the answer being 500.

So every year you keep your money with that bank, you’ll see an increase of $500.   So consider if you wanted to see what would happen to your money in 20 years.


?? = 10000*(.05)*(20) with your final answer being 10000.  Now remember this is the amount of interest you will have accrued in 20 years.  So your ending balance will be $20,000.  Not too bad, right?


Well let’s look at the same numbers, but with compounding interest, rather than simple interest.  Essentially, the first year will remain the same.  You’ll still receive $500 in interest at the end of the year, but here is where the bonus comes.  As you start the second year, you build interest on $10,500 rather than your original principal amount.  And each year going forward will be the same.   You will continue to see the amount of interest you earn increase as your principal + interest increases.


Here is a formula for compounding interest:

Future Value = Principal Value × (1+interest rate)n   Where n =the number of years

So let’s use the same numbers as above to illustrate the point.  You have $10,000, with an interest rate of 5%.  After twenty years …

?? = 10000 x (1 + .05)20   with your answer being $26,532.98.

Pretty stark differences, right?  (Note: the value you receive in the second formula is all of the money, not just the interest.)  Regardless, you’ll see that with compounding interest, you have earned an additional $6,500.

To play with a compounding interest calculator, click here.  This calculator will allow you to spend some time seeing the differences between simple and compounding interest.


Retirement plans, like a 401k or 403b, all work with compounding interest.  This is one of the major factors that influenced how much money was saved in our earlier example with George and Jane.  By using the principle of compounding interest effectively, George was able to accumulate $100,000 more than Jane, simply by starting five years sooner.


It may be hard for you to think about retirement now, in your twenties, but you’ll find that it’s much easier to start now than later.  By waiting even a year or two, you’re costing yourself large amounts of money in the long run.  Thus, even if you can only spare $100 a paycheck, it will be worth it.

Consider this scenario to better understand starting now rather than waiting until later.  There are four individuals all investing the same amount of money.  Each individual contributes money into their retirement for ten years, then stops and simply lets the money grow until retirement.  Investor #1 contributes $5000 a year starting at the age of twenty-five.  Investor #2 contributes $5000 a year as well, but starts at the age of thirty-five.  Investor #3 contributes $5000 a year, and starts at the age of forty-five.  And finally, Investor #4 contributes $5000 a year, starting at the age of fifty-five.  They all plan to retire at 65 and each is receiving an 8% rate of return on their account.


Investor #1 – After ten years, the total will be $72,431.  From the age of 35 to 65, Investor #1 contributes nothing else, and just leaves his money to grow.  At the age of 65, Investor #1 has $728,848 saved in the retirement account.


Investor #2 – At the age of 45, Investor #2 also has $72,431, but now only has twenty years to watch it grow.  At the age of 65, Investor #2 has $337,597 saved in the retirement account.


Investor #3 – When this Investor stops contributing at the age of 55, the total is also $72,431, and has ten years to grow before retirement.  At the age of 65, Investor #3 has $156,373 saved in the retirement account.


Investor #4 – Now Investor #4 contributes and saves for ten years, but after ten years, this Investor plans to start using the money.  Thus there is no time for the money to “continue growing” after the contributions stop.  So Investor #4 has saved $72,431 in the retirement account.


By looking at each of these investors, you can see how starting young can make a huge difference.  Each of these investors contributed the same amount of money into their retirement – $50,000 ($5,000 x 10) – but their ending balances were widely different based on the amount of time the money grew in the account.  Thus remember that time is your friend when saving for retirement.

Let’s look at one final example to help illustrate the point.


At twenty-five, you have just graduated from college, finding your first job making $65,000 a year.  When you first start your new employment you meet with a retirement representative to set up a 401k.  This retirement rep convinces you to contribute 15% of your annual income every year to your retirement.  (As your annual income increases, so will your retirement contributions.)  So your first year, you will be contributing $9750 or just over $400 a paycheck into your 401k.  Remember your paychecks are over $5000, so $400 is a small amount.  If you continue to make these 15% contributions every year, at age 65 you will have $3,047,998 saved in your 401k.  (We are assuming a few things, like your interest rate and inflation costs.)  Remember although three million sounds like a lot of money, you’ll need to live on that for somewhere between 25 and 35 years.  So divided into each year, you’ll have $122,000 to live on.


Now let’s take the same scenario, except when you meet with that retirement rep you decided to wait a few years until you feel more financially stable.  Now remember you need to save at least three million dollars, but now you’re starting to contribute to your retirement at age thirty instead of twenty-five.  Let’s do the math and see what that does to your monthly paychecks.   By age thirty, you will probably be making around $79,000 after yearly raises (we are assuming a 4% yearly increase).  In order to achieve the same goals of having three million at retirement you’ll need to contribute 19% of your annual salary to retirement.  That means your fifth year working, at age thirty, you’ll contribute $15,000 or $625 a paycheck.


In other words, by being willing to contribute now, you’ll save yourself 4% of your paycheck in the coming years.  Now like we talked about before, if you can’t afford 15% right now, figure out what you can afford even if its only 3% or 4%.  Then as you pay off other debt and become more financially stable, you’ll be able to increase your contributions to 15%.


Although financial planners and retirement representatives are helpful, the initial planning process is something you can do yourself.  Here are the first steps to figuring out your retirement needs.


  1. Decide how long you will need retirement money – this involves two things.  First you’ll need to know your life expectancy.  You can use online life expectancy calculators to help you determine this, or you can make a good educated guess based on the health of parents, grandparents, etc.  The second decision you will need to make is at what age you are going to retire.  Most people like to retire around age 65; there are even some industries that force retirement at this age.  So putting these two numbers together, you’ll be able to figure out how many years you’ll need retirement money.  For example, let’s say you determine your life expectancy is 90 and you want to retire at age 70.  That means you’ll need twenty years of money to live on.
  2. How much money do you need/want at retirement – basically, ask yourself what kind of a salary you want to live on during your retirement.  Of course you could survive on $30,000, and you would live in luxury at $1,000,000 a year.  Instead of going to either extreme, try to find something in the middle that will allow you to live comfortably, but also doesn’t kill your paychecks now.  Most people determine their salary from a year or two before retirement and decide on a percentage of that salary.  For example if you were making $200,000 the year before retirement you could choose to have a salary of 70% of that salary, giving you $140,000 annually.  Maybe this number is too high or too low for the style of life you want to live.  If so, adjust it accordingly.
  3. Determine your retirement goal – so now that you know how long you’ll need retirement money and how much you anticipate needing each year, you can find the total amount you need when you retire.  Using the numbers we have already talked about, let’s say you need twenty years of retirement at $140,000 a year.   This equates to $2,800,000.  That becomes the golden number you want to reach in your retirement savings when you retire.
  4. Determine amount to contribute annually – with these numbers in mind, you can determine how much you need to contribute annually in order to reach your goal.  Using some numbers we’ve used before, let’s determine your annual contribution.  If your initial salary is $65,000 and we expect a 4% income increase, and you want to accumulate $2.8 million for twenty years of retirement, you’ll need to contribute 12% annually into your retirement savings.  This is $7800 your first year, or $325 a paycheck.  (We are assuming a modest 7% interest rate for this exercise.)


Determining these amounts can give you a great start to your retirement planning.  With these numbers in mind, you can walk into a meeting with your retirement advisor feeling informed and knowledgeable about your plan for retirement.  Your advisor will then help you with all of the smaller details and the best plan to help you reach your goal. By following these four steps, you’re well on your way to being prepared for retirement.  


Looking at this retirement calculator, let’s talk about each of the individual pieces of information they are asking from you.  Some of them are obvious, but some of them may not be so obvious.


Current Age: This should be obvious; however, if you’d like to compare starting to save at different ages – this would be a good tool to do so.  Change your current age to an age you think you’d like to start saving at and then note the differences in numbers.


Age of Retirement: As we talked about earlier, here is the place where you will put the age at which you plan to retire.  Again, just like with your current age you can play with this number to see what happens to your retirement funds based on what age you plan to retire.  See what happens if you want to retire early say at 55 instead of 65.  Or how the numbers are affected if you decide to retire at 70 rather than 65.


Annual Household Income: Here you will place your current salary in your industry.  Now like almost all people, we hope that our financial situation will improve as the years progress, and this calculator will take that into consideration (see Expected Income Increase).


Annual Retirement Savings: Here they would like you to decide a percentage of your income that you plan to save every year.  Because the calculator will adjust your income with an annual salary increase, it will also use this percentage to determine your retirement contribution each year.


Current Retirement Savings: This box only applies if you already have some retirement saved in an account.  If you don’t have anything saved, put a zero in this box.


Expected Income Increase: Unless you have a fixed idea on the percentage your salary will increase each year, leave this number at 3% (the national average).  If you have seen something like a salary schedule that indicates a different percentage, feel free to change that number to something more aligned with your salary.


Income Required at Retirement: Again you’ll need to decide on a percentage.  The calculator will take whatever percentage you put here against the salary you were making during your last year of work.  For example if you put that you plan to live on 60%, and your last year’s salary is $180,000, you are looking at a annual salary of $108,000.  Remember as we talked about earlier, you most likely won’t need 100%, but you’ll probably need more than 50%.  Playing with this number as well, will give you an opportunity to see what kinds of retirement salaries you can expect based on the contributions you make.


Years of Retirement Income: You should already have a general idea about this number for our exercise earlier.  Based on your life expectancy and the year you plan to retire, you’ll find a number to indicate how many years you will need retirement money to live.


Rate of Return Before Retirement: This is the interest rate you expect to receive during the years you are saving for your retirement.  Although this number can vary from year to year based on the market, your decisions to invest, etc., you can generally expect a 7% return.  This is a very modest number, and most people will see something higher, especially in the early years, but to be safe, use something around 7%.  Later in the book we’ll talk specifically about the rate of returns you can expect based on the portfolios you choose.


Return During Retirement: Once you have entered retirement, it’s not as if you can’t continue to earn interest on your money.  Since you are only pulling out a fraction of it every year/month, you can still expect to earn something with the money that continues to sit in the bank.  In order to keep the money safe, and prevent any loss, most people move their money into smaller interest accounts, but ones with little to no risk.  Thus, your rate of return during retirement will be significantly smaller, but you can assume a modest 4% if you don’t have any idea.


Expected Rate of Inflation: This is a national rate that the country plans to see over the next forty years, or until your retirement.  Again, this number should be left at 3% unless you feel or have seen research stating otherwise.

Then you will see that there are spaces available for you to check if you are married and if you want to include social security.  Checking the married box will only change your numbers if you also ask it to include Social Security (married couples receive up to 1.5 times as much annually as a single person). Reliance on Social Security should be approached with caution (see the discussion on government programs in our next section).  Although it is fine to look at it as part of your retirement, we would also suggest planning without it to ensure financial stability.


After you have entered all of the numbers into the calculator, you’ll see a graph and information about your retirement accounts.  These are general numbers, but you will see how much money you’ll accumulate before retirement and if it is enough to sustain you through your expected years of retirement.  If you find that your funds run out before you expected, try playing with a couple different numbers to see how you can reach your goal.  You can change your age of retirement or how much you contribute each year in order to have your goal attainable.  If you have an immense surplus at retirement, consider changing these numbers as well.  Look at retiring earlier or contributing less.  However, it’s never a bad idea to have a little extra in your retirement, so don’t sell yourself short when making these decisions.


Overall the calculator is there to help you see the effects of saving and to help you with your expectations.  Use this calculator prior to speaking with a financial advisor or retirement counselor.  By doing so, you’ll have a better idea of the numbers you are looking to obtain by retirement.  Once you start talking with a financial planner, together you’ll create the perfect plan for you.


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