Monday, July 26, 2021
July 26, 2021

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Personal Finance: Financial advantage of youth? Compound growth


Adulthood these days involves a financial obstacle course. Out of the gate, demands on your starting paycheck include college loan repayment, likely a car payment, and don’t forget rent, utilities, food.

Doing all that on a starting salary is painful. But there’s one area of personal finance in which the young hold a huge advantage: saving for retirement. Starting in your early 20s, rather waiting until 30 or 35, puts you in a position to harness the full power of compound growth.

Time: The secret sauce to savings

Quite simply, the longer you give each dollar saved to grow, the more you’ll have in the future. That means you’ll need to save a lot less of your paychecks to achieve a savings goal.

For instance, if you start saving at age 22 and save for 50 years, you would need to plunk $240,000 of your own money into savings to end up with $1 million, assuming a conservative 5 percent annualized rate of return. The other $760,000? You can thank compound growth for doing the work.

But if you wait until age 37, to end up with the same $1 million or so by age 72 will require you to shell out $378,000 of your own money, a nearly $140,000 penalty.

As noted, that example used a conservative 5 percent annualized rate of return. Historically (dating back nearly 100 years), if you kept 70 percent of your retirement savings in U.S. stocks and 30 percent in U.S. Treasury bonds — a 70/30 portfolio — you would have earned more than 7 percent annualized each year. (Annualized means the “average” return over all the years; in any given year returns will be a lot higher and a lot lower than the average annualized return.)

Using a 7 percent annualized gain: If you start saving $400 a month – that’s $100 a week, or about $13 a day — at age 22, you’ll have $2.18 million by age 72. If you start saving at 37, and set aside the same $400 a month, you will have $720,000. No typo there. Just compound growth doing its thing.

An aside: Before you assume that $720,000 is plenty, slow down. Inflation is not your friend. What costs you $100 today will cost $270 in 50 years, assuming a very benign 2 percent inflation rate.

If you want till age 37 and are determined to hit $2.18 million by 72, you would need to save about $1,200 a month. Sure, you may be earning more at age 37 than at 22, but $1,200 is still a big drain, at a time when there are other claims (house, raising kids) on your income.

At this point you’re likely sold on compound growth, but you might view saving anything right now as too difficult. You simply can’t come up with $100, $200, $400 a month to take full advantage of compounding.

This is where another rule of financial adulting comes into play: setting priorities that will help you not just today, but way down the road. Need extra motivation? Ask your parents if they have any financial regrets. According to surveys, 50- and 60-somethings typically put “not saving earlier for retirement” as their top financial regret.

Here’s how to avoid that regret:

Get motivated. A quick web search of “periodic savings calculator” will land you at a free tool. Plug in your numbers and get a personalized spin on how saving $X per month, or week, will grow over time. Run the calculator at least three times. The first time, plug in the number of years between your current age and age 72 (or 65, or whatever you envision as when you will start to live off of retirement savings). Then run it again assuming you wait 10 years to start saving. And again assuming you wait 15 years. “Rate of return”? 7 percent is fine. If you want to play it safer, maybe ratchet it down to 5 percent.

Right-size your spending from the get-go. Some costs are fixed (student loans, for instance), but much of your monthly spending is also a choice, even the essentials. Need a car? OK, how little can you spend to get a reliable used car that gets you to work?

Moving out of the house? Great. Again, how little can you spend right now? Roommates? A smaller place? For the city folk, a less hip neighborhood?

Don’t rely on work to set the right savings amount. If you’ve landed a job that provides a workplace retirement plan, congrats. If your employer automatically “enrolled” you in the plan, that’s a mixed blessing. It’s fantastic that you are saving for retirement. But many employers typically start you at 3 percent of salary, which is way too low.

It’s easy to override; contact Human Resources and tell them what percentage of your salary you want to save. Retirement wonks recommend getting to a contribution rate of 10 percent to 15 percent of gross salary ASAP (that includes any company match if you get one). If you’ve avoided lifestyle creep, that’s going to be reachable. Then you can sit back and let compounding do the heavy lifting.