Retirement planning is like taking your vitamins or eating those leafy greens… you know you should, but … can’t it wait until tomorrow? “Millennials ” (roughly those born between 1975 and mid 1995) are especially vulnerable to this attitude because retirement is so far in the future. Even as those of you in Gen Y respond to the Great Recession with a focus on financially responsible behavior, you’re facing the worst job market in memory, shouldering record amounts of student loan debt and still hoping to buy a home in the not too distant future. Given this environment, many Millennials just don’t see retirement savings as a priority yet. Why save now for something so far off when you’ve got more immediate priorities? There will be plenty of time to catch up later . . . won’t there?
The answers to “why now” are that (1) contributions to your retirement plan reduce your taxes now and (2) the “magic” of compounding interest means that small amounts saved now are better than larger amounts saved later. Whether it’s a qualified IRA (Individual Retirement Account) you establish at your bank or an employer-sponsored retirement plan (like a 401(k), or 403(b)), contributing to a retirement plan really won’t make a huge dent in your take home pay today, but it will make retirement less stressful and more like, well, retirement.
How does this work? Let’s start with our first answer: contributions reduce your taxes now. In the case of an IRA, this means your contributions are deductible from your taxes when you file your tax return in April. With an employer-sponsored plan, contributions are taken out of your paycheck on a pre-tax basis, meaning that the payroll taxes you pay are calculated on lower earnings. Why is this important? It means that either way, less of your money goes to the government. More of it ends up available for your own use, both now and later. Even small amounts set aside in your early 20’s can grow significantly in the next 40 years, which leads us to our second answer, compounding interest.
Compounding interest may or may not seem complicated, depending on how well you did in math class. For those of you who might have missed the finer points, here’s a really basic description:
- “Principal” is the amount of money in your retirement account that you earn interest on.
- “Interest” is the amount of money that you earn on the principal from the bank or financial services company. For example, earning five percent (5%) interest means that for every dollar ($1) of principal, you will earn five cents ($0.05) in interest.
- “Compounding Interest” means that as you earn interest, the bank adds it to your principal instead of mailing you a check. This is an important tool because now you are earning interest on your original principal and all of the interest you’ve earned up to that point.
When you’re young, time is your greatest ally and compounding interest is like rolling a snowball down a mountain. As it rolls down the mountain it picks up more snow and gets bigger, which means that as it keeps rolling it picks up even more snow and gets even bigger even faster and . . . well, you get the point. If you wait until just before retirement to start saving, time is your greatest enemy and you’re rolling your snowball down an ant hill.
Let’s look at quick example using the assumption that you retire at age 65 and that you can only get an average interest rate of only 2% on your savings (and it’s likely to be higher than that over the course of 40 years):
|
Starting Age 25 |
Starting Age 60 |
| Open Retirement Account with: |
$ 1,000 |
$ 14,000 |
| Interest Rate: |
2% |
2% |
| Weekly contribution: |
$ 50 |
$ 350 |
| Years of Contributions Until Retirement: |
40 |
5 |
| Total Amount Contributed: |
$105,000 |
$105,000 |
| Total Interest Earned: |
$ 56,515 |
$ 6,191 |
| Total Retirement Savings: |
$161,515 |
$111,191 |
It doesn’t take a rocket scientist to figure out that having more money for retirement is good. Having more money for retirement is even better when it comes from someone else’s pocket, like the bank that’s paying you interest.
While we’re on the subject of other people’s money, if you have an employer-sponsored retirement plan, ask if the company provides a matching contribution. A matching contribution means that for every dollar you save for retirement, your company will match a certain amount (it varies by company). This is free money, so don’t pass it up!
Here’s the difference it can make, using the same example from above:
|
Starting Age 25 with Employer Match |
Starting Age 25 |
Starting Age 60 |
| Open Retirement Account with: |
$ 1,000 |
$ 1,000 |
$ 14,000 |
| Interest Rate: |
2% |
2% |
2% |
| Weekly contribution: |
$ 50 |
$ 50 |
$ 350 |
| Employer Match |
$ 10 |
$ 0 |
$ 0 |
| Years of Contributions Until Retirement: |
40 |
40 |
5 |
| Total Amount You Contributed: |
$105,000 |
$105,000 |
$105,000 |
| Total Amount Employer(s) Contributed: |
$ 20,800 |
$ 0 |
$ 0 |
| Total Interest Earned: |
$ 67,573 |
$ 56,515 |
$ 6,191 |
| Total Retirement Savings: |
$193,372 |
$161,515 |
$111,191 |
Investment Options
Once you decide to open a retirement plan, don’t let the investment options presented to you when you sign up put you into analysis paralysis (I’ve been there; trust me, it’s a useless, twitchy place).
In the examples we gave above, we assumed you were borderline paranoid about the stock market and put all of your retirement funds in super-safe Treasury bonds or Certificates of Deposit insured by the government. If you invest that money more aggressively (read: more risky), you are likely to do better over the long term, but you could also lose some of that money, too.
If you want to invest more aggressively but you’re a slacker, look to see if your plan offers a target fund. Target funds automatically adjust their investments based on a planned retirement year. For instance, this year a 25 year-old planning to retire at 65 would choose a fund that matures in 2049. This fund will gradually get more conservative (think: “less risk,” not politics) as the years go by.
If you’re a control freak, or if your provider doesn’t offer target funds, the Wall Street Journal suggests this simple formula:
“… Subtract your age from 100, with that amount going into stocks. It’s simplistic, but it gets you closer to where you need to be. So, for instance, if you’re 25, you’d want about 75% of your 401(k) contributions going into stock funds.”
But remember the lessons of 2008-2009: nothing is guaranteed in the stock market, and you can experience big losses – especially in the short term. If you are more afraid of losing money than you are of missing out on potential gains over the long term, tell your broker you are “risk averse” and ask them about more conservative investment options. Remember, when it comes to your retirement account, you’re the one calling the shots.
Pensions & Social Security
A lucky few of you may have the opportunity to participate in a pension plan. In a pension plan, the employer agrees to pay you a certain amount each month during your retirement based on your earnings and length of employment with the company. If you haven’t heard of a pension plan, it’s because the employer-sponsored pension plan seems to be going the way of the Dodo bird. According to worldatwork.org, the number of Fortune 1000 companies that have frozen their pension plans has more than quadrupled in the past five years. This is unfortunate, but it’s just one more reason to start your own retirement plan. If you don’t take care of this yourself it just won’t get done.
But what about Social Security, you ask? Right now, the average Social Security check equals only about 40% of pre-retirement earnings. And, if nothing changes, the Social Security trust will be depleted on 2037 anyway… well before energetic, interesting 25-year-olds become old, boring and eligible to retire. If Social Security is still around when Gen Y retires, super. Just don’t count on it. Make your own plans.
It’s understandable that a lot of 20-somethings are putting off saving for retirement. But a 25 year old who puts only $12.50 (or the cost of three lattes) a week into a retirement account, invests it wisely and earns an 8% average rate of return would have an additional $175,000 if they retire at 65 years old. That’s literally money in the bank.
To learn more, read:
When I graduated from college in the early 1990’s, the job market was a mess. I scrambled to find a job…any job.
