In our retirement workshops, we often look at the components of retirement savings as a simple mathematical formula:
What is most important?
Recently, one of the participants in one of my workshops asked which variable or component is most important. My initial gut instinct was to do some math.
- Savings – $110 x 5% x 20 years = $44,638
- Return – $100 x 5.5% x 20 years = $42,887
- Time – $100 x 5% x 22 years = $47,256
What are the takeaways from this?
- Rate of return is the sexiest variable but maybe the least important over shorter periods of time. In this example, a 10% increase in return had the lowest impact on results over a 20 year time horizon.
- Rate of return can have a greater impact over longer periods of time because of the math of compound interest but it is also the variable you have the least control over. It is impossible to know what markets, interest rates, economies, etc. will do looking ahead into the future. What I find interesting is the investment industry has been built on a platform of guesswork, predictions and forecasting. Everyone is trying to out guess and out predict each other and yet it’s the least effective strategy in improving returns. That being said, return leaks over long periods of time can have a significant impact on the future value of your retirement assets. An example of return leaks is high Management Expense Ratios (MER).
- Time has the greatest impact but unfortunately too many people are impatient. Everyone I meet wants to retire sooner than later. We are all trying to achieve financial freedom as quickly as possible and the dream is that high returns will help us get there faster.
- Since time is so important it goes to highlight that the biggest risk and the biggest cost to your future value is PROCRSATINATION. Start saving early. The sooner the better. Don’t wait.
- If you are results oriented and you want to have the greatest impact on your future nestegg, its critical that you focus on what you can control and not what you can’t control. The simplest variable that will impact your financial future is your savings rate. Make it automatic, make it simple, increase your savings.
A final thought
Although I think I’m pretty good at math, I reached out to a math guru and fellow personal finance blogger, Micheal James. His comment really puts all this math in perspective:
“My take on this is that the question of whether savings, return, or time is most important is like asking which is most important, your brain, heart, or lungs. You need them all. If you don’t save anything, you’ll end up with nothing. If you lose 50% every year on penny stocks, you’ll end up with next to nothing. If you save for less than one year, you’ll end up with little. Getting any of the three elements wrong can derail your retirement. The good news is you don’t have to shoot for the moon; just be reasonable in all three area and you’ll get good results.”
What are you thoughts on the formula for retirement success?