If you had a nickel for every time someone told you to start saving and investing early…well, you’d be rich by now. Here’s how to do that and retire a millionaire.
People in their 20s and 30s usually have big student loan bills, are just starting their career and think they can’t afford to save and invest for a far-away future. But they can and should. Here’s how.
A recent college grad who just entered the workforce was offered the chance to enroll in the company’s 401(k). She wants to know why she should save for retirement.
Here’s how behavioral finance experts answered her question:
A Little Bit Becomes a Lot
Meir Statman, Glenn Klimek Professor of Finance, Leavey School of Business, Santa Clara University and author of “Finance for Normal People: How Investors and Markets Behave and What Investors Really Want:”
“In 1975, when I was a Ph.D. student at Columbia, I taught at the City University of New York. My annual salary was $13,500. The University established a 403(b) account for me and contributed to it. I added to it. Those few thousands grew to more than $100,000.”
“It is true that today’s $100,000 buys less than 1975’s $100,000. Inflation matters. But $100,000 is a good amount of money, even today.”
“Subsequent contributions brought my savings into the many millions.”
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Build the Future That You Desire
Eben Burr, president, Toews Asset Management:
“It is hard for your young people to think of their tight skin sagging and their backs aching, but perhaps even more than that is to imagine how they could possibly set money aside for some unknown need half a century away. Who is this gross old person that it would be for and why wouldn’t some other version of themselves save that money at another time?”
“Most recent grads have student loans, and the new obligations of adulthood can be overwhelming. How could she possibly put any money into an account for a future version of herself she can’t envision, when she is barely scraping by right now?”
“I get it. Most young people are living in the moment in a way that we all seek later in life.”
“Future orientation is an emphasis on anticipated consequences of actions taken now. In other words, it is making choices in an attempt to create the future that one desires, focusing on long-term success. Planning and delaying gratification are two pillars of this concept.”
“What is the future that she desires?”
“I would suggest thinking of an older person in her life that is comfortable, enjoys more leisure, and has a softer life. Then contrast them with another person of a similar age she knows that has suffered because they have had to forgo pleasures to work longer or simply is just getting by. Which one does she want to be?”
“Tiny amounts of savings now build muscles that allow for greater saving as salaries increase and the reality of aging does too. Small sacrifices now, that do not even seem consequential enough to matter in the long run set up habits that can last a lifetime and help cushion old age for that incomprehensible future version of the recent grad.”
“While it may seem hard to plan for some amorphous future, don’t worry about that, just start to flex your future a tiny bit every pay period and then don’t look at it more than once a year, preferably by an expert. Portfolios grow best in the dark.”
The Longer You Wait, the Harder It Gets
Sarah Newcomb, director of Behavioral Science, Morningstar:
“If you don’t at least contribute enough to get your employer match, you are effectively accepting a lower salary. Do you really want to take a pay cut just so you can spend every possible dime?”
“If you start saving at 22, you can build a very large nest egg without having to save very much. The longer you wait to start saving, the more you will have to sacrifice to make up for it. For example, if you start saving $150 from each (bi-monthly) paycheck at 22, and that 401(k) earns 7.5% per year on average, you’d have over $1 million to retire on when you’re 65. That’s if you never increase your savings, and even without an employer match! If you wait until you’re 32 to start, you’ll have to save twice as much from every paycheck to reach the same goal, and if you wait until you’re 42, you’ll have to save four times as much. By starting now, you can keep the amount you have to save small, and as you earn more, you can spend more, knowing you’re all set on the savings front.”
“If you have this amount automatically deducted from your paycheck, you probably won’t even feel it. If it never hits your checking account, you’ll never miss it!”
Time Is Your Friend
Megan McCoy, professor of Practice in Personal Financial Planning and director of Personal Financial Planning Masters Program, Kansas State University:
“My favorite response comes from a great book by Morgan Housel called ‘The Psychology of Money.’ In that book, he talks about the importance of saving early and how compounding interest works so well for young people. In the book, Housel describes how Warren Buffett is the richest but not the greatest investor of all time. He goes on to explain that Buffett started investing at 10 and most of his wealth was actually acquired after he turned 65. It was not investing prowess that made him his remarkable 96 billion dollars… but rather time. If he had waited to start investing (like most people) at 22 and had stopped investing (like most people) he’d probably only be worth somewhere in the $12 million range. To put that in perspective…A million seconds is 12 days. A billion seconds is 31 years. He is worth $96 billion because he invested as early as possible. A recent college grad should start saving for college as early as possible so that they can make the most out of time just like Warren.”
The Miracle of Compounding
Erik Davidson, adjunct professor of Finance, Baylor University, Hankamer School of Business:
“Here’s why:
Because no one else will be doing that for you. Your future self will thank you!”
“Because you are not saving for retirement…you are investing for your retirement. While you may not have much money today, the one thing you have on your side is time. Time is your great ally. Because of compounding, every one dollar that you invest today will be worth $117 in 50 years (assumes the long-term average return of 10% for the S&P 500).
“Because if your employer is offering any sort of “match,” then you are getting “free” money. That represents a 100% return in the first year for every dollar that you invest. You don’t want to miss out on that.”
“Because in a 401(k), your investments will grow tax-free as well as be tax-free going in (traditional 401(k)) or tax-free going out (Roth 401(k)).”
You’re Building Wealth
Victor Ricciardi, visiting assistant professor of finance, Washington and Lee University and co-editor Investor Behavior and Financial Behavior:
“A 401(k) plan allows companies to match your own investment contribution. For example, if the retirement plan offers a 100% match and you contribute $3,000 per year; the company will then contribute a $3,000 match. This is equivalent to a 100% return on your money.”
“If you begin investing for retirement in a 401(k) plan at age 22 and save $3,000 each year for the next 40 years and earning a 9% return, investing in a diversified mutual fund portfolio (including stocks, bonds, and real estate), when you turn age 62 you would have in excess of a million dollars.”
“Since retirement is over 40 years from now; do not think of this as a retirement account. An individual should frame a 401(k) plan as a ‘wealth account’ that allows the investments to grow tax-exempt for many years since with this type of account you avoid taxes on dividends, interest, and capital gains.”
“The contribution from your paycheck is based on your gross salary and this is even more tax savings with a traditional 401(k). For example, if your top federal tax bracket is 24%; for every $1,000 you contribute; you will save $240 in taxes. In other words, that is an extra $240 that you can contribute to a stock mutual fund.”
How Much Should You Save?
Tom Armstrong, vice president, Customer Analytics and Insight, Voya Financial:
“Newly minted college graduates are faced with making many choices about how to allocate their new paycheck across needs, wants, and savings. At Voya, we would generally advocate for first setting up a budget following the 50/30/20 rule — allocating 50% of your take-home pay to needs (housing, food, transportation, and debt payments including any student loans), 30% to wants (entertainment, dining out, etc.) and 20% to savings (emergency fund, retirement, savings for other goals).”
“Once a budget is set, we would absolutely encourage taking advantage of one’s employer-sponsored retirement savings program. Investing early allows your money to grow and take advantage of compound interest over time and with a workplace retirement plan, contributions are deducted directly from your paycheck, making saving, and starting to save, much easier. Many employers today also offer some form of a match meaning they are matching your contributions, often up to a certain percentage. By choosing not to fully participate in these programs, you are effectively giving away ‘free money.'”
“When it comes to determining how much you should be saving, while there’s certainly no one-size-fits-all approach, as everyone has unique goals and needs, at Voya we believe that most individuals should be saving enough to generate at least 70% of their pre-retirement income in retirement. We typically find that participants who are on track to achieve a secure retirement (as defined by on target to meet that 70% of income replacement) are usually saving at least 10% to 15% of their salary. However, any contribution today can help for the future. Making all of these decisions can be difficult, but taking a few simple steps such as setting up a budget, starting an emergency fund and taking advantage of workplace benefits like a retirement plan can get you started on a great path to future financial success.”
