Myths - You Can Have A Financial Windfall Only If You Save Early

Many advisors use a chart as shown below as an attention getter about how much you can make if you save early. 

* Assuming 12% return on assets

If from their advice, you believe that you can save during the first 5 years out of college and then coast to retirement, you would be wrong.  If you believe that because you did not save when you were younger that you now have no hope of catching up, you would be wrong again.  The goal should be first to understand that you have different financial priorities at different times of your life, and second that you should save as much as you can (even if it is a small amount) with a plan to build up your retirement savings over time.  However, you do not need to save $2,000 a year when you first graduate from college earning $22,000 a year in an entry-level job while having student loans to payoff. 

Before you kick yourself for not saving $2,000 a year from ages 21 to 25, there are a few things to consider:

• A 12% return is difficult to achieve.

• The example above does not consider inflation. To be realistic the $2,000 should increase over time to account for inflation.

• People may have other financial priorities when they are younger - for example, paying off student loans and raising a family, all while starting at the bottom of the corporate ladder with relatively low pay.

First, when you remove the impact of using a 12% rate of return and use 8% or 10% instead, the exaggerated effect of saving $2,000 for just 5 years diminishes.  Realize that to get a 12% or more return consistently may require you to be the next Warren Buffet or take undue risk with your money. 

The savings at age 65 with lower investment returns would look like:

So the effect of not being able to save early is not as dramatic.

Second, the other inconsistency in the example is that the value of $2,000 is consistent through out one's life.  First, due to inflation, the value of $2,000 at age 21 would be equivalent to $6,300 at age 60.  So it should make more sense to increase your contributions over time to account for inflation.  In addition, as you get promoted or receive pay increases (above inflation), it becomes easier to save a part of the pay increase for your retirement.  Thus, if you factor increasing your savings by 4% a year, you would have saved the following amount by age 65:

Age	Save Early	Wait a Little Longer	Waited Too Long
21 - 25	$2,000 for 5 years	$0	$0
26 - 35	$0	$2,000 for 10 years*	$0
36 - 64	$0	$0	$2,000 for 29 years*
10% Return
Flat $2,000	$527,000	$530,000	$312,000
w/ 4% increase	$567,000	$751,000	$802,000
8% Return
Flat $2,000	$245,000	$281,000	$216,000
w/ 4% increase	$264,000	$400,000	$580,000

*2,433 at age 26 and $3,602 at age 36 to reflect the 4% annual increase

So, saving early does help. However, it is never too late to start especially if you increase the amount you save over time to reflect inflation and promotions.  For example, with a 10% return, saving a flat $2,000 from ages 36 to 64 would only amount to $312,000 at age 65.  However, by adjusting the savings by 4% a year (and starting at an adjusted $3,602), your savings would actually grow to $802,000.

Lastly, there are many factors that may limit someone from saving early in their career, including having children, saving for a down payment on a house, and paying off student loans.  In the typical financial life cycle of a family, each age group has a different financial focus.

Age	Financial Focus
20 - 30	Paying off student loans and saving for a down payment on a house
25 - 50	Extra expenses for children and their education
45 - 65	Extra savings for retirement

I mention this because I meet many people in their 50's and 60's wondering what they are going to do about saving for retirement thinking that it is too late.  The key is to determine what your financial priorities are at different times of your life and to set up a plan with these priorities in mind, which may mean saving less for retirement earlier in life and catching up with retirement savings after the children go to college. 

In looking at a typical working career, saving 5% throughout a career (from ages 21 to 66) is equivalent to saving 18% from ages 45 to 66 based on an 8% return and 4% salary growth.  This may sound like a big increase and good reason to save 5% throughout your career instead of 18% after age 45.  However, with the cost of raising children and saving for their education fund, there is a significant increase in available funds when the children-at-home phase of your life is over.  This does not mean that you should wait until your children go to college before you start saving money for retirement.  You should still save some money early on (especially if your company provides a 401(k) match) and expect to increase it when your children go to college with an additional payment when you pay off your mortgage.

Where people tend to go wrong is that when their children leave home, they plan on taking the long needed vacations that they deprived themselves of over the years without a clear goal of how much they need to save to catch up on their retirement savings.  Retirement savings is a slow and steady process, the pace of which normally needs to be picked up when the children leave the nest.  The key is in your younger years to form good savings habits.  This may mean saving just $25 a month at the beginning and increasing it each year.  It does not mean that you necessarily need to break the bank in your younger years to save for retirement or save at the expense of buying a house and starting a family.

Lastly, because financial priorities are never on a fixed timetable, it is important to remain flexible.  For example, if you and your spouse are planning to have children in your mid-30s or later (as my wife and I did), you should plan to save for retirement before you have children.  Because by the time your children leave for college, you will be in your 50's and 60's which will leave little time to catch up on your retirement goals.  Do not fall into the trap of carefree living in your 20's and 30's without any financial commitments.  If so, these carefree days will catch up with you and may require you to work into your retirement years in order to catch up.

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