Several weeks ago, I attempted to write a post about compound interest and the caveats involved in that. I soon realized that I wasn’t explaining my point right, and yanked the post. But I’m back at work on it as I’m writing about savings and retirement for my (as yet untitled) money book.
What I was attempting to say is that a common theme of personal finance books is to tell people that saving and investing small amounts of money over time adds up, due to the miracle of compound interest. This is true, to a degree. For instance, if you invested $3000 a year in the S&P 500 from 1970 to 2009, you would have achieved a rate of return of 10.38%, and the $120,000 you’d invested would have turned into $1.625 million. Investing $6000 per year — just $500 a month — would give you $3.251 million.
This is a fair chunk of change. But there are a few things to keep in mind. Most notably, this doesn’t take into account inflation. Investing $3000 a year seems relatively doable now, in 2010. This is less than $10 a day. Cut out a few coffees, lunches, movies and mall trips and you could probably find the cash. Saving $6000 a year would be more of a stretch, but this is still only 12% of the average household income of $50,000.
Saving $3000 a year back in 1970, however, would be an entirely different matter. The average household income then was less than $9000 per year. Telling a young person then to invest $3000 a year would be like telling a young person now “Hey, all you have to do to have a secure retirement is invest $17,000 per year!” True, but not particularly helpful. In terms of household income, $6000 would have the sticker value of about $34,000 today. Very few 25-year-olds can sock that away.
That doesn’t mean that people shouldn’t save for retirement. The best reason is that most retirement funds are tax advantaged, plus many employers match contributions. So that’s easy money. Which is why it’s fascinating to learn how little most people have saved up. I’ve spent some time today reading the Employee Benefits Research Institute’s 2010 Retirement Confidence Survey. Some 54% of workers have less than $25,000 in savings and investments. Only 18% of workers who are older than 45 have more than $250,000 in savings. The survey notes that many people underestimate how much money they’ll need for retirement, though this is partly a matter of how you calculate it. If you use the rule of thumb that you can pull out 4% of your assets per year, pulling out just $2000 a month ($24,000 a year) would require you to have at least $600,000 in assets.
Anyway, what all this points to is that most people would find it very difficult to save up enough of their income from ages 25-65 to live for 20-30 years with no new money coming in. I don’t want to get much into Social Security, but far from being an argument for the program, I’d note that Social Security has the same problem in that it’s not clear that overall payroll taxes are enough to support multi-decade retirements either. That’s why people are worried about its solvency.
But here’s a different question: why are we so into the idea of retirement? The whole financial planning industry is based on this idea of having enough money to not work, and yet surveys of Americans find that two-thirds of adults say that they would continue to work if they won the lottery. Perhaps people are thinking that, if they were financially secure, they’d be able to do work they loved and not think about money first. But then that suggests this idea: instead of fixating on retirement, we should put that same mental energy into figuring out what kind of work we’d never want to retire from.
To be sure, we will probably all reach some age where we will not be capable of working. But for many of us, that is not 62. Indeed, given that I’m home with a 1-year-old today due to a babysitting issue, I’d wager that I will find it easier to focus on my career at 62 than I do at 32!