Thursday, May 7, 2009

Why It's Important To Save For Retirement

Tip #134 - Why It’s Important To Save For Retirement. Most people begin their working lives at about age 20 – plus or minus a few years. At age 20, people have an overall life expectancy of about 80 years old. So when you being working you have, on average, 60 more years to live. If you work until the day you die, you don’t have to save for retirement. But most people do not want to or won’t be able to work until they are 80 years old. In that case, you need to save for retirement. Think of it this way – from age 20 to age 80 is 60 years’ worth of living expenses. If you only want to work (or are only able to work) for 40 of those years, then you will have 20 years with no income. So 40 years’ worth of paychecks needs to cover 60 years’ worth of expenses. And that is why you need to put money away from each paycheck to fund your retirement. It is that simple.

It seems funny to save for retirement when you are fresh out of college, but the earlier you get started on this habit the better, as you have longer time to save and time for interest to compound. But let’s forget interest for a moment and take inflation out of the equation. Let’s go over a very simple example of why you need to save for retirement. Suppose you make $50,000 per year from age 20 until age 60. That is $50,000*40 (years) or $2 million total. From age 60 to age 80 you do not want to work, so your income for those 20 years is $0 total. How do you live for those 20 years? We’re not going to count on Social Security. If it comes, it will be a nice bonus and you can do something special with it. But let’s assume it doesn’t. You need to live on some of that $2 million dollars that you earned over the previous 40 years. So let’s say, from age 20 to age 60 you live on only $40,000, saving $10,000 per year for retirement. That means from age 20 to age 60 you will live on $40,000 ($1.6 million dollars total). And from age 60 to age 80 you will live on $400,000 total or $20,000 per year ($400,000/20). That might be okay. Expenses are often cheaper in retirement. Hopefully, you house will be paid off so you won’t have that big expense. But maybe you want to do better, so you live on only $35,000 during your working years and save $15,000 per year for retirement which means you will have $600,000 to live on in retirement $30,000 per year, which is probably better with income being only slightly less than when you were working.

Of course this is just a very simple with many realities taken out of it. In reality, what you save will grow exponentially over the years because of compounding interest. Of course, inflation will eat away at some of that interest, too. Your income will not be steady for 60 years either. And there are really tax benefits to saving for retirement. But this basic example shows why it is important to understand why people must put money away for retirement year after year. It is not to save so you can live on a tropical island in your golden years. You are simply covering the living expenses you will have when you will not be working. And the earlier you start saving, the less you need to put away each year.

In Real Life (IRL) – When I got my first job, I remember sitting in the human resources office the first day, and the benefits specialist telling me that I would be eligible to participate in their 401(k) after 1 year of service. “Okay,” I answered not really caring one way or another. I was just interested in having an income and some health insurance. But after a year rolled around, the benefits specialist informed me that I was now eligible to put money into the 401(k), and that they would match dollar for dollar the first 3% of my salary that I put in. Because the match of “free” money sounded good to me, I put in 3% of my salary, even though saving for retirement – a good 40 or so years away - sounded a bit extreme.

During that year, I spoke to my father and an older man at work, and both of them advised me to put in as much as I could into the work retirement plan. Not only would I get a tax benefit, but I remember specifically the my older co-worker saying, “You won’t even miss the money since it comes out before you get your paycheck.” So the following year, I put in the full 13% that the company allowed. And my co-worker was right! I was saving for retirement painlessly because I didn’t even see the money that I was putting away. From that point on, I got accustomed to living on less than I earned.

I eventually started putting even more money away for retirement in an IRA account and then when my children were born and I worked part-time or not at all, I stopped contributing to my 401(k) altogether. Thank goodness I put money away for retirement in those early years, when I really didn’t have high expenses – I shared an apartment with friends and I had no family depending on me. I am grateful for the good advice some wiser, experienced investors gave me. I’ve written a few other posts on saving for retirement, including one that linked to a retirement calculator to figure out how much you need to save each year. But the purpose of this post is to show the very basic reason why it’s important to put money away each year for retirement. Unless you die the day you stop working, you will need money to live when you don't make an income.

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