Taking Stock of Your Financial Future, Part 2

Because planning and saving for distant financial goals isn’t easy, it’s best to break this process down into smaller and more manageable steps. Take retirement for instance, many people want to know if they’re on track, and yet, few can confidently assess or even quantify their overall level of preparedness. Though estimating how much money will be needed to maintain a desireable future standard of living without the aid of an income is a tricky and frustratingly imprecise task, it's a good idea to begin with a ball-park appraisal of how much retirement costs. The problem with slapping a price tag on something as dauntingly huge as retirement is that there are lots of variables to consider and just as many ways for the delicate financial calculus to go horribly awry. Unless you've got a properly calibrated crystal ball that can peer into the distant future and accurately predict things like inflation, investment returns, personal longevity and health care costs, there's no way to know exactly how much money you might need to keep your golden years green. Throw in a wide range of personal lifestyle preferences and the cost of supporting them, and it quickly becomes glaringly apparent that an individual's retirement number bears a striking resemblance to snowflake in that no two are exactly alike.

Fortunately, when it comes to determining how much wealth you’ll need to accumulate over the course of your life to enjoy the good life without having to work for a paycheck, there’s a simple back-of-the-envelope approach to crunching the numbers that automatically compensates for many of the key variables. In fact, if you follow the somewhat tedious multi-step process that I'm about to outline, you'll have a remarkably accurate estimate of your retirement number. Luckily, this discovery effort--let's call it the retirement price tag quantifier--can be safely trusted to produce a savings target that will be nicely customized for your individual requirements. That’s the good news. The bad news is that it will require a good deal of effort on your part to produce worthwhile results. Begin by gathering and organizing a bunch of old receipts. Haven’t got any old receipts to work with? Fine, stockpile them until you’ve got one or two years worth of receipts to work with. The idea here is that you want to compile a complete and comprehensive record that accurately details all of your spending. Naurally, this will require tallying outlays for everything from housing and transportation to phone and cable bills, groceries, restaurants, and other incidentals. Now, once you've neatly categorized and subtotaled your spending and have determined how much money is needed to support your lifestyle during an "average" year, multiply the whopping total by a factor of, say, twenty-five. By all means, if you want to live dangerously (and aren’t averse to running out of money when you're elligible for senior citizen discounts at the movies) then, by all means, feel free to experiment with a slightly smaller number--though I'd recommend against using a value that's less than 20.

Assuming your lifestyle and expenses don't dramatically increase in future years and you've invested an appropriate amount of energy calculating your number, you'll have a reasonably accurate sense for how much wealth it'll eventually take to loft yourself into a dreamy and largely self-sustaining financial orbit. Rest assured, when your net worth approaches this amount, you'll not only have your economic cake, you'll be able to eat it too. Now, after allowing ample time for the enormity of your retrement savings goal to sink in, take stock of your emotional pulse. Is your retirement number a scary number? It should be... The Number, by Lee Eisenberg, is an easy to read no-nonsense guide that offers a more in-depth explanation of how to approach the arduous task of determining how large a nest-egg you'll need. Believe-it-or-not, developing good savings habits and establishing a constructive wealth ethic early in life is important. Shrewd economic choices made early in life and throughout one's 30s and 40s can, through the magic of time's wealth compounding power, mean the difference between just eking by or living-it-up in the not-too-distant future. The takeaway point? Retirement is expensive; so, when contemplating it, brace yourself for high-voltage sticker shock. Even if the prospect of retirement seems vanishingly remote and the idea of saving for it now seems absurdly premature, know that it looms somewhere down the calendar like the financial equivalent of Mt. Everest. For reasons that will be readily apparent in good time, the hard work of planning and saving for it shouldn’t be put-off another day.

Now, when it comes to amassing the magnitude of wealth you'll need to live the retirement lifestyle of your dreams, I’m afraid that I've got good news and bad news. What’ll it be first? Okay, we’ll start with the bad news… Although saving diligently, early, and often is absolutely essential to bankrolling a dignified retirement lifestyle decades from now, the unsettling reality is that the difficult lifelong process of saving money, though vitally necessary, may not be enough to propell you to your retirement savings goal. But don't despair; before consigning yourself to a bleak future in which you're old and gray and swaddled beneath a heap of blankets shivering for warmth with a cold bowl of oatmeal clutched in one hand while you're seated before the drafty chill of a vacant fireplace—here’s the good news. Are you ready? Thanks to capitalism’s buoyant long-term record, as evinced by well over 80 years of stock market history, people with modest means, a decent savings ethic, a long investment time horizon, and a fair amount of investment knowledge should be able to bridge the financial gap between what they can comfortably afford to save on a regular basis and what they’ll one day need to retire in style.

To prove that the good news scenario alluded to above isn't just a cruel hoax, we'll analyze the lifelong financial behaviors of three made-to-order retirement crash test dummies. On a conceptual level, using manikins to illustrate complex financial concepts and reinforce the importance of economic choices will, I think, add a welcome touch of levity to an otherwise touchy and emotionally charged topic. Thanks to the somewhat whimsical nature of the three-way retirement race that's about to get underway, and the fact that our experimental subjects are inanimate objects whose long term financial needs (and whether or not they're ultimately met) won't cause anyone acute emotional distress, we can, with near clinical detachment, focus on the long-term results of this interesting fiscal experiment. Moreover, this scenario will enable us to focus on each crash test dummies' economic choices and, over a lengthy 40 year span, trace their distinct financial behaviors to their eventual outcomes. Sit tight; this will be an informative lesson in fiscal physics that you won’t want to miss.

To establish the ground rules of this fiscal experiment, let's start by identifying the similarities and differences between our crash test dummies with respect to how they each manage their day-to-day financial lives. Though they're equally diligent savers who set aside equal amounts of money in lockstep with one another over the course of their professional lives, we’ll soon see that the amount of wealth that they each accumulate has surprisingly little to do with how frequently or even how aggressively they save. Remarkably, it’s what they do with their hard-earned savings that has the greatest influence on their long-term results. So that we won’t have to impatiently wait around for 40 long years for the results of this fiscal experiment to materialize, we’ll take the easy way out. We’ll accomplish this by strapping each prosthetic retirement contestant into a fancy electronic chair. Shortly thereafter, we’ll flip the switch in the time control room and, presto, dispatch each of our intrepid contestants to the distant past. Borrowing from the storyline to James Cameron’s hit film The Terminator, in a haze of dazzling lights and special effects, our crash test dummies will re-materialize from out of thin air and be borne into a world of gainful and uninterrupted employment.

Of course, our prosthetic contestants work tirelessly and with machine-like persistence toward the realization of their retirement dreams: which, for our purposes, is $1,000,000. To achieve this worthy goal, they consistently set aside $145 from each and every paycheck that they earn throughout their careers, which, incidentally, will last exactly 40 years. Because dummy # 1 is obsessed with keeping his hard-earned retirement money safe, he stuffs every last dollar into his mattress at home. Dummy # 2, however, isn’t quite so risk averse and plows his retirement savings into certificates of deposit that yield rock-steady 4% annualized returns. In sharp contrast to dummies # 1 and # 2, however, dummy # 3 is a financial daredevil. He invests his retirement savings in a diversified mix of stocks. Although the magnitude of dummy #3’s wealth fluctuates dramatically over any one or two year period, this volitility eventually dissappears, leaving 11.15% annualized returns in its wake. Mind you, this number wasn’t plucked from out of thin air. According to Ibbotson Associates Inc., a well-known market research firm, this lofty rate of return exactly match the stock market’s average yearly performance from 1926 to 2002.

Now that the rules governing how this fiscal experiment will unfold have been clearly defined, let’s sit back in the time-control room. We’ll kick up our feet, enjoy a refreshing beverage or two, and allow the pages of the calendar fly by. Time will accelerate on its not-so-merry way, but we'll stop the clock exactly 40 years from the moment that our hopeful retirees begin working for a paycheck. Of course, calculating the results of this financial experiment will require crunching the numbers. Let's see; since each crash test dummy is paid twice a month, or 24 times a year, a 40 year career produces a whopping total of 960 paychecks, which, when multiplied by $145 (the amount that each saves each paycheck), produces a baseline savings of $139,200.00 for each of our retirement contestants. Dummy # 1, who imprudently used his savings as glorified mattress stuffing, misses his million dollar savings target by a country mile. Inching to retirement at this sloth-like pace, I estimate that he’d have to work another 247 years to stuff his mattress with a million bucks—and this rosy estimate doesn't take into account inflation’s wealth biting effects. It’s a good thing that a crash test dummy’s plastic parts don't quickly wear out. Were this not the case, dummy # 1 might not reach his retirement savings goal at all. Advances in healthcare and rising life expectancies notwithstanding, a flesh and blood person might not be so lucky. What about dummy # 2? Because his wealth compounds at a considerably faster non-zero clip, he ends up with a lot more money at the conclusion of his 40 year career: $343,340.00, to be precise; which, unfortunately, is still frightfully short of his million dollar savings target. As you can see, although dummy # 2 handily beats dummy # 1 to the retirement finish line, it will still takes him 23 additional years of working for paychecks to get there. What’s more, if inflation were factored into Dummy # 2’s financial results, the purchasing power of his nest-egg would shrivel to $163,330. How about dummy # 3, that swashbuckling yahoo? Certainly, he risked greater volatility in the day-to-day value of his savings to achieve greater long-term returns. But, the million dollar question is: are the stock market’s returns high enough for him to realize his lofty savings goal? Amazingly, because dummy # 3’s retirement money grows at a considerably faster 11.15% annualized clip, he not only reaches his million dollar savings target, he surpasses it--and with an extra $2.64 million to spare.

At first glance, Dummy # 3’s outsized end of career fortune seems suspiciously large. At first glance, the numbers don’t make sense. How can dummy # 3’s 11.15% rate of return, which, to be fair, is just under dummy # 2’s 4% annual rate of return, go on to produce nearly 7.7 times more wealth? The enormous disparity in their retirement wealth seems to defy common sense. How can a nearly three-fold disparity in annual growth rates produce a nearly eight-fold difference in wealth over a 40 year interval? Rest assured, the numbers have been triple-checked, and they're correct. The moral of this financial fairy-tale is that the wealth-building power of higher compounding returns acting over a multi-decade period are truly astonishing! In fact, the mechanics of compound interest are so extraordinary that Albert Einstein dubbed this mathematical phenomenon the “most powerful force in the universe.” Even with inflation’s wealth withering affects taken into account (estimated at 3.22% per year), dummy # 3 still crosses the retirement threshold with the purchasing power of a million bucks. 

Make no mistake, when it comes to planning and saving for distant financial goals like retirement, the simple act of saving, though still vitally necessary, isn’t always enough. To be sure, though dummy # 1’s mattress-minded ways certainly protected his wealth from the poorly perceived risk of loss, he ultimately pays a steep price for the illusory peace of mind that it affords. Ironically, dummy # 1’s pathological fear of financial loss is largely responsible for his disastrous results. Similarly, though dummy # 2’s retirement savings earn a comparatively higher non-zero rate of return, it’s not nearly high enough for him to reach the million dollar mark in 40 years. In sharp contrast to the first two dummies, however, dummy # 3’s results are astonishing. In his case, it’s as though a financial magician reached into a cavernous black top hat, and, with some effort, extracted a wheel-borrow full of crisp and neatly stacked hundred dollar bills. What’s not readily apparent in dummy # 3’s case, however, (because 40 years of stock market history was conveniently glossed over in the blink-of-an-eye) is that the gut-churning volatility that he had to endure over 40 long years in the stock market was anything but pleasant. To be sure, if a crash test dummy had a real stomach and actual nerves to match, he surely would’ve lost his cookies—on numerous occasions. At times, the stock market treated Dummy # 3 so harshly that, were he an actual person, he would’ve been sorely tempted to pull the proverbial rip cord and bail out of the stock market altogether. Of course, in the midst of those dark and trying times, nobody would’ve questioned his sanity or thought any less of him for doing exactly that. Fortunately, however, we see that dummy # 3's intestinal fortitude and indifference to the short-term volatility in his wealth are richly rewarded.

Now, a few words of caution are in order. Just because a statistical accounting of stock market history shows that it produces average annualized returns of 11.15% from 1926 to 2002 doesn’t mean that it can be counted on to produce similar returns over any similar future interval. Nor, for that matter, does it mean that the stock market actually produced a return of exactly 11.15% over any 12 month span during that lengthy 77 year period. Bear in mind, 11.15% is just an average, which means that for half of those 77 years, the stock market produced returns that were good or better. For the other half, however, it posted returns that were worse, in some cases much worse. Over one or more decades, however, the stock market’s volatility responds to capitalism's influence and human nature's tireless ingenuity when faced with a profit incentive. So, despite its volatility and manic mood swings, over a ten or twenty year period, the price chart of any widely-followed stock market index (i.e., the Dow Jones Industrial Average, Wilshire 5000, or S&P 500) traces a nice upward sloping line. It's worth emphasizing, however, that throughout its long history the stock market has witnessed the threat of nuclear holocaust and experienced two world wars, a presidential assassination, the great depression, and just about any other calamity that a thinking species can throw at it. And yet, despite these horrific events and recurring systemic shocks, the stock market has risen seven out of every ten years dating back to 1928. Interestingly, over this lengthy span, the market experienced 57 up and 24 down years. The upshot is that the longer one remains invested in the stock market the less risky investing in it becomes.

Paradoxically, although stocks have historically offered the best long-term returns, it’s unwise to load up on just stocks. Why emulate the narrow minded money management philosophies of dummies 1, 2, or 3 when you can sensibly blend the best elements of all three? Although dummy # 1’s overly conservative approach to managing his personal finances eventually lands him in the poor house, don’t be mislead by his disastrous end of career results. There’s a place for cash in any portfolio. It’s a good idea to keep some handy at all times so that, should the market unexpectedly slide, you can take advantage of the fleeting opportunity to snap up high-quality cash generating businesses at irrationally depressed prices. Similarly, although stodgy investments like bonds and CD’s aren’t partricularly exciting, their steady plodding performance lends a worthwhile element of stability to an otherwise volatile all-stock portfolio.

In short, it’s best to have a little cash here, a few safe and stodgy investments there, and the bulk of one’s retirement savings in stocks. The bottom line: when it comes to planning for distant financial goals like retirement, it pays to make smart choices. More importantly, with enough time on your side, you needn’t save a lot of money on a regular basis to wake up a millionaire one day. The important thing to remember is that it’s never too early to begin saving and you can’t afford to manage your money too conservatively. Don’t learn what dummy # 1 or dummy # 2 learned the hard way. When it comes to achieving faraway financial goals, it pays to think beyond the mattress.