Compound Interest And The Road To Retirement: How To Fund Your Future

Retirement

Roughly 75% of Americans over the age of 40 are failing to keep up with saving for retirement, and close to one-third report that they have no retirement savings at all. With the future of Social Security somewhat unclear, preparing for retirement today is essential to funding your future. Oddly enough, in my experience, I find that many individuals approaching retirement have not considered how they will generate income once their paycheck goes away. Sure, you may receive $20,000-$40,000 in Social Security benefits, but that simply may not be enough to cover the rising cost of healthcare, general inflation on goods and services, and any emergencies that may come up in a 20- to 30-year retirement period. That doesn’t even include any of the fun stuff, and isn’t that the point of retirement, at least to some degree? You’ve worked hard for the past 40 years or so, and now it’s time to enjoy the fruits of your labor. If you haven’t prepared for retirement properly, those fruits might not be what you’ve hoped for.

As you travel down your road to retirement there are important milestones to consider and routes you can take to help you reach your destination. One wrong turn can lead to a much longer journey. One of the biggest mistakes I see is procrastination. It got us in trouble when cramming for a college test, and it’s getting us in trouble now when preparing for a successful retirement. Putting a road map in place is essential in making informed decisions on how best to proceed. If your savings aren’t properly invested, every day that goes by, you are losing time and, more importantly, losing the benefits of compound interest. The first step on the road to retirement is finding your “retirement number.” Sounds cliché, doesn’t it? However, identifying this number will help you determine how close you are to achieving your desired retirement lifestyle. Your retirement number is the sum of liquid assets needed to produce a targeted cash flow stream in retirement.

As we go through these examples, keep in mind that the numbers we use can change based on your specific lifestyle, but the concepts and general math will remain the same. For example, let’s say you spend $100,000 in aggregate before taxes each year. If a $100,000 lifestyle is what you want to live in retirement, then you need to know how much that lifestyle will cost in future dollars, factoring in the impact of inflation on goods and services. So, if retirement is 20 years from now, and we use an assumed long-term U.S. inflation rate of 3.5%, at retirement, you will need roughly $198,000 to live a similar lifestyle. Maybe you want to travel more in retirement and spend $120,000 annually, or maybe you simplify life in retirement and project you will only need $80,000 per year. In either scenario, be sure to apply the inflation rate over the remaining years left to your retirement date.

Once you have estimated your future cash flow needs, you should subtract any fixed income from sources like Social Security, pensions or rental real estate. Let’s say these sources in aggregate provide roughly $80,000 of annual income. Therefore, the true annual shortfall required from your asset base is $118,000 ($198,000, the amount needed per year of retirement, minus $80,000, the amount of annual income). The general rule of thumb is that you don’t want to spend more than 4% of your investment assets on an annual basis. This so-called 4% sustainable distribution rule is meant to provide a retiree with a withdrawal rate that will allow the asset base to sustain over a 20- to 30-year retirement period. To find your number, simply divide your shortfall by 4% (in this case, $118,000 divided by 0.04), which gives us roughly a $2.9 million target for accumulated assets by retirement.

Now that you know approximately how much you may need in retirement, you’ll need to design a savings rate and investment plan to get you there. Here’s where compounding becomes essential and why procrastination is a killer of retirement success. Let’s say Lucy starts saving at 30 years old for 10 years at $18,000 a year. She stops at age 40 and doesn’t save another dime. Her total contributions were $180,000. Alex, on the other hand, starts saving at age 45, at $18,000 a year for 20 years. The sum of contributions for Alex was $360,000. Assuming both Alex and Lucy earn an annualized rate of return of 7% and they turn 65 at the same time, Alex will have roughly $789,000 at age 65, where Lucy will have $1.4 million. So, as far as saving for retirement — there truly is no time like the present.

Finally, once you’ve determined how much you need to save (my suggestion is as much as you can), you will have to assume a growth rate and tax drag on your investments. Remember, when we began this example, I noted a $100,000 lifestyle before taxes. Tax rates are a constant variable and somewhat unknown, as are investment returns over the short run. From a tax perspective, the best you can do is use current tax law to provide a tax-efficient environment for your assets. Utilizing strategies such as Roth conversions, tax-loss harvesting, asset location, 1031 exchanges, installment sales and charitable trusts can help reduce the tax burden on your investments. Every dollar saved on taxes is another dollar added to your retirement number. As Americans, paying taxes is our duty, but overpaying certainly is not.

Taking the time now to work through your personal retirement expectations and making some simple projections will help you decide how you plan to fund your future, but as far as when — start today.

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