August 11, 2010
Bernard from Birmingham, AL writes:
I can’t seem to save well enough for retirement. Any suggestions?
The typical advice given to answer your question is to examine your expenses and prioritize those that are most important. In other words, find a way to cut your costs (or increase your income). Low hanging fruit is often reducing high cost debt, cooking instead of eating out, and keeping your car longer (switch cars every 6 years instead of every 3 years). Having said that, let’s focus on the psychology of our choices…our motivation.
Human nature, especially in this day and age, keeps us focused on immediate gratification. Thus, forgoing benefits now, for the sake of future benefit (retirement) goes against many individual’s nature. We often inadvertently sacrifice long term benefits for perceived short term benefits. The key to changing these habits is to gain perspective on the benefits of saving now.
Let’s say John and Susan earn $100k/yr. They probably give up $35k in federal and local taxes. Let’s presume they spend $60k/yr on expenses, and have no high cost debt (such as credit cards), leaving them $5k/yr in savings to invest. (Remember, if you have high cost debt, it is generally more cost effective to pay that off before investing.) This scenario actually puts John and Susan far ahead of the typical American family.
Our fictitious family probably wouldn’t bat an eye at spending $100 on an additional monthly expense. It could be a cell phone bill, a night out, or the monthly payment on a piece of furniture…take your pick. After all…they earn $100k/yr! What’s $100/month expense for them, right?
Most people look at the wrong denominator. Meaning, $100/month relative to $100k/yr seems like a small number. Instead, let’s look at it relative to their savings. $100/month, which is $1,200/yr is actually 24% of their $5k/yr savings!! This means in retirement, our family’s ANNUAL INCOME would be affected by 24%…EVERY YEAR. Try to keep this perspective when making small purchases. They really do add up!
Invest or Pay Down Debt?
As mentioned above, it is often more cost effective to pay off high cost debt before investing. Consider the following example.
You bought a car 2 years ago, for $30k, with a 4yr loan (nothing down) and your interest rate is 6%, making your monthly payment $704.55. With 2 years left, you owe $15,896. Conveniently, you have that $15,896 in your bank account and you can do one of two things; invest that money in a 2 yr bank CD (risk free) or pay off the loan in its entirety. What do you do? Let’s evaluate the options.
Given that a 2yr CD currently yields 1.5%, that $15,896 would be worth $16,373.59 in 2 years. That is an annualized rate of 1.5% (CDs are quoted on an annualized basis).
To calculate the value of paying off the loan, we take the total of the payments (including interest) that you would have paid, plus the opportunity cost of investing the payments in a risk-free account for two years yielding 1.25%. In total, the value of paying off the loan comes to $17,111.78, or 3.82% annualized.
So if you look at paying off your own debt as a risk free investment, you are earning a much higher rate than you would in a CD.
Effect of Increased Savings
As discussed above, when we look at the cost of a purchase vs. savings, we often use the wrong denominator. Let’s consider how a small change in savings impacts our retirement income. To illustrate the effect of saving an extra $100 a month, let’s look at a more detailed example.
We’ll go back to John and Susan who earn a combined $100k/yr and currently do a good job saving $5,000 per year. Let’s assume they save for the next 35 yrs (they are 30 now…and plan to retire at 65). With an assumed long term growth rate of 8%, a tax rate upon retirement of 30%, and an income production/distribution of 5%/yr, they will generate $2,745.82 per month, after taxes (we won’t debate if that’s enough…). What if they save an extra $100 a month, or $6,200 per year? With the same financial assumptions, they will expect to receive $3,404.82 per month, after tax. That is 24% more income at retirement for only another $100 a month! Note that it is the same 24% increase to what they are saving (1,200/5,000). So, remember, each time you decide to spend vs. invest, keep in mind the relative number is not your current gross income….but rather your current savings rate!
Now for all of you skeptics out there who are yelling “BUT WHAT ABOUT INFLATION???” Assuming an average long term annual inflation rate of 3.7% (TIPS are only pricing in 2.2%, one of the reasons why we like them…), $100 of goods would cost you $356 in the future. That is still $300 less than the benefit you would get from saving an additional $100 a month.
We hope that helps and provides fodder for discussion. Please let us know if we can be of further service!
The Friedenthal Financial Team
Please send us your questions!! If we don’t know the answers, we’ll find someone who does!
If you know someone who would like to discuss their investment needs with us, we certainly appreciate the introduction.