Don't Let the Money Control You: Saving Smart for Lifelong Security
Let’s face it; most of us find dealing with personal finances a pain.
Unless you’re making millions of dollars like the head of a huge multinational company and don’t need to worry about exhausting your money tree, chances are you’re concerned about making your money last throughout your older years.
Even if you fall into the upper middle class, you’re still likely concerned and thinking about how you will maintain your lifestyle if you stop working past 65. You probably don’t expect or want to suddenly downgrade your quality of life after you reach a certain age. So, you should plan to make sure you can, at the very least, remain at the level of living that you’ve become accustomed.
Money is quite often one of the single biggest sources of stress in life. The other, which is discussed in the next section, is work. Marriages often break up over disagreements about finances, either because one partner is too careless with the cash or the other is too selfish. Money, or the lack thereof, is a great destabilizer in people’s lives. Money can often control people because they don’t know how to control it.
It’s ridiculous to discuss aging well without touching upon finances. As mentioned in previous chapters, there’s no doubt wealthier people tend to have a greater chance for healthier lives. Money is a great determinant of health. Consider that those living in the poorest parts of the United States often possess the highest mortality rates.
Yet time and again you have probably heard the same old thing: Americans are frighteningly unprepared for retirement. As a society, Americans live on borrowed money too much, piling up debt to live beyond their means. Some do not know how to invest in the stock or bond markets. Many are living paycheck to paycheck.
Taking control of your aging means you unequivocally must take control of your money. Only then—and this is important—can you truly plan for the future.
Several excellent books can help you learn more about investing. To understand why it is so hard to pick individual stocks and beat the market, read Burton Malkiel’s classic Random Walk Down Wall Street. To understand why stocks in general are necessary as part of your overall wealth portfolio, read Jeremy J. Siegel’s Stocks for the Long Run. Another book, The Millionaire Next Door, takes a great look at why saving is so important for your financial future. The Millionaire Next Door makes the useful point that it is how much you save, and how well you avoid debt, and not just your earned income that can help you become a secure millionaire. In light of this, the focus of this chapter is how to save early, continuously, and smart.
It is also well worth your time to sit down with a financial planner, even if it is only for a free consultation (American Express, for instance, offers free sessions for card members). You don’t have to hire this person, unless of course you like him. You might not be able to afford his services just yet. The point is that you need to start taking steps (even small steps) that will reinforce the point that you are taking control of your money.
When dealing with personal finances, it can seem as if too much information and conflicting advice is out there. Throw in personal fears and aversion to or tolerance for risk and no wonder many people remain paralyzed when planning for retirement. If this applies to you, know that you are not alone. Even financial planners fail in dealing with their own financial futures. Take heart that everyone has a difficult time dealing with their own personal finances because they are just that—personal.
This section of the book aims to filter out the noise and outline a clear strategy for thinking about your finances. Remember that your objective is not to become the savviest stock picker on Main Street, but to simply organize your finances so that you are intelligently well prepared and positioned for your future. It doesn’t matter that the next guy says he made millions investing in something like Google stock; what matters is that even when the stock markets go bust or the bond markets tank, you’ve got some clear tools and strategies to help you face the future confidently while everyone else scrambles to cover their losses.
It Always Begins with Saving
Our first strategy is a maddeningly simple one: save, save, save.
Why maddeningly? Because if everyone followed this advice, no one would have to worry so much about retirement.
Americans have one of the worst savings rates in the world. Many Americans live on credit because they have saved so little, whereas Asians sit on piles of cash. In many Asian countries, savings rates reach 30 percent of incomes. Amazingly, and perhaps to an extreme, savings rates in China have risen to 50 percent. Picture the future leadership in the global economy if Chinese save and invest and Americans continue to borrow and spend!
A large part of the relatively high savings in Asia has to do with the fact that many Asian countries still do not have mature credit markets or credit-rating agencies, so people find it difficult to borrow money.
For those readers who have not yet started a steady and adequate saving strategy, don’t feel guilty about not saving. However, do realize that one absolutely crucial element to financial freedom is to save a substantial portion of your income and to start saving early. Numerous studies support the idea that it is your saving behavior—even more than your skill or luck at picking investments—that ultimately is the main driver of your wealth accumulation.
It is important for you to save early, significantly, and consistently throughout your working life. A rough rule of thumb is to save about 20 percent of your income, even if your income is low. This is just a rough rule because you may have to save more to "catch up" if you start to save rather late in your working life. As one example, later in this chapter, we present a savings scheme by the Schwab Center for Investment Research that is tailored for people in specific age brackets. We offer no explicit endorsements, but the scheme is clear. A strict savings rule may not be easy, but the point is to adjust your lifestyle expectations. Control your spending behavior, if needed.
Twenty percent of your income may sound steep. Consider, however, that the definition of savings, at least according to economists, is all the income you put away instead of consuming. This is not just money put into your bank account but also added to your stock and bond portfolios, IRA, 401(k), and any other investment vehicles. Note the difference in this definition of savings versus the more colloquial usage of "my savings"; that is, "my total money in the bank." Total money in bank accounts and similar deposits are regarded as part of the asset class termed "cash" in your overall investment portfolio. Savings, on the other hand, are considered added flows into your investment portfolio, which then get allocated into different asset categories, such as stocks or bonds or simply cash.
The earlier you start saving, the more you’ll benefit from the joys of compound interest or compounded returns on your investments. If you start early, you have a lot of time left for your investments to earn interest on the prior interest you continuously earn, as well as on the amount you save and invest. Due to compounding, your wealth doesn’t grow in a straight line, it grows exponentially.
The following figure illustrates the concept that savings invested early do not just grow at a straight line or linear rate, but at an accelerating or exponential rate. Starting your saving early will lead to a dramatically higher amount of wealth when you reach more senior ages. The results are so significant that learning and applying the lesson of saving early can indeed dramatically boost your financial freedom and security in later life.
The graph shows the amount of pre-tax money you will have at age 70 in a tax-deferred account if you save $10,000 at various age points. Saving a solid sum starting even as late as 60 can make a big difference by age 70, and, of course, even more so if you keep it invested beyond age 70, especially if you stay invested aggressively and achieve an 8 percent average annual return.
The figure also illustrates the impact of going for a portfolio of 8 percent average returns versus a more conservative one of 6 percent average annual gains. Obviously, if you can create an investment portfolio that has a good chance of giving you higher returns, it makes a big difference. However, the main point illustrated is the importance of starting as early as you can. Even if you feel it is too late, don’t worry. The important thing is to start now.
The power of compounding is shown by the two "start at age 30" bars. At 6 percent annual returns, you would have a very respectable sum of over $100,000 at age 70 on your $10,000 initial investment. So, the first key is to start as early as you can.
The second key is to invest boldly enough to gain those extra percentage points of growth over time. You can see how just a few percentage points of return can make a big difference. Starting at age 30, if you can achieve 8 percent annual returns on average, you will have a whopping $217,245 by 70. This large sum is nearly 22 times the money you put in and more than twice the total if you earned a 6 percent return on average.
How do you get such a wonderfully multiplied sum from a modest initial investment? A handy rule used by financial professionals is the "rule of 72." It is a simple mathematical equation, as follows:
72/% Rate of Return = Number of Years for Money to Double
This tells you approximately how many years it will take for your money to double if you earn a certain percentage rate of return.
For example, if you earn a 4 percent return in a bank certificate of deposit (CD) or a U.S. Treasury note or bond, you must wait almost 18 years to see your money double (72 divided by 4 is 18). At 6 percent, you reduce the doubling period to 12 years (72 divided by 6 is 12). Eight percent gets exciting as you double your money every 9 years. Naturally, 9 percent average returns, compounded continuously, mean you can double your investment in merely 8 years.
The key to compounding at constant growth rates is that it leads to exponential, not linear or straight-line, growth. Take a look at the following figure, which shows the exponential growth path of a $10,000 investment. Note in particular the sharp upturn associated with the 8 percent return.
The good news is that it is never too late to start saving, just like it is never too late to reap substantial benefits by starting the right exercise program (see Part I, "Your Body"). It is better to save aggressively in your 50s and even 60s than to try to live on only a small Social Security check after you retire.
If you start saving late, you must save a greater proportion of your income. This is logical because you must make up for lost time and lost longer-term compounding benefits. The Schwab Center for Investment Research has some excellent guidelines on how much of your income you should save as you age.
If you start saving steadily while still in your 20s (bravo for you!), you can usually save only 10 to 15 percent of your income. This should be enough to generate a substantial nest egg for you if maintained throughout your career.
If you wait until your 30s before you start saving, you are like many average Americans, so you need to consistently save between 15 and 25 percent of your income.
If you wait until your 40s, you need to save between 25 and 35 percent of your income. Sure this sounds steep, but you have to make up for lost time accumulating wealth.
Clearly, people in their 50s and 60s who have not saved are behind the curve. However, don’t get depressed. Just know that it is never too late to start. If possible, save 30 percent and, ideally, an even greater proportion of your income. If this is not possible, do what you can to stay in mental and physical shape because you will likely need to continue working for a while. Follow the advice earlier in this book: Find some work you love and you won’t dread your later years. Indeed, the work may keep you active, productive, and feeling great about those later years.