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 a series of smaller and more manageable steps. Take retirement for instance, many people want to know if they’re on track, and yet, surprisingly few can confidently assess their overall level of preparedness. And it so happens that there's a prefectly good explanation for this: it's nearly impossible to determine how much cash will be needed to indefinitely support one's standard of living. But take heart, while this might be technically true, there's a clever way to estimate how much your retirement costs. Now, the problem with arbitrarily slapping a price tag on something as dauntingly huge as retirement is that there are many key 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 foggy future and accurately forecast things like inflation, investment returns, personal longevity and the worrisome trajectory of health care costs, you can't definitively know how much money you'll eventually need to amass in order to be somewhat well-off in retirement. Throw in wildly variable lifestyle preferences and the associated costs of supporting them, and it quickly becomes apparent that retirement numbers resemble snowflakes; no two are exactly alike.

Fortunately, when it comes to estimating how much wealth you’ll ultimately need to live well in retirement, there’s a simple back-of-the-envelope approach to crunching the numbers that automatically compensates for a metric ton of economic uncertainty. In fact, if you follow the simple multi-step procedure that I'm about to outline, you'll have a pretty good handle on your retirement number. Luckily, this labor intensive process--which I call the retirement price tag estimator--can be trusted to produce a lifetime savings target that reflects your individual requirements and unique lifestyle preferences. This is the good news. The bad news is that it takes a considerable investment of time and effort on your part to produce worthwhile results. You can start 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 living expenses to work with. Ultimately, you want to have a complete detailed record of all your day-to-day, week-to-week and month-to-month expenditures. Naurally, this will require tabulating outlays for everything from housing and transportation to phone and cable bills, groceries, restaurants and other incidentals that enter into your financial picture. Now, once you've categorized and subtotaled your spending and have figured out exactly how much money it takes to support your present lifestyle for a year, multiply the 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 before running out of time) then feel free to experiment with a slightly smaller number--though I'd caution against using a multiplier of less than 20.

Now, assuming your lifestyle and living expenses won't substantially change, you'll have a realistic estimate of how much money you'll need to loft yourself into a dreamy and largely self-sustaining financial orbit. Rest assured, when your net worth approaches this celestial magnitude, you'll not only have your economic cake, you'll be able to continually eat it too. Now, once you've allowed ample time for the enormity of your retirement savings number to sink in, take stock of your emotional pulse. Is your retirement number a scary number? It should be... The Number, by Lee Eisenberg, offers a conversational yet deeply insightful step-by-step explanation (for those of you who're interested in exploring this topic in graphic detail, I recommend picking it up) of how to size-up the right nest egg for you. Believe-it-or-not, proactively developing good savings habits and establishing a constructive wealth ethic early in life is critical to the eventual success of this important lifelong process. To be sure, shrewd economic choices made throughout one's 30s and 40s can, through the magic of time's wealth compounding power, mean the difference between getting by or living large during one's golden years. The takeaway point? Retirement is expensive; so, when it comes to the mundane yet necessary work of feathering your nest and bracing yourself for the jarring financial impact of retirement, be prepared for high-voltage sticker shock. Even if the prospect of retirement seems absurdly remote and the idea of saving for it now seems rediculously premature, make no mistake, it looms menacingly over a vast expanse of years like the financial equivalent of Mt. Everest. For reasons that will be much clearer one-or-more decades from now, planning and saving for it shouldn’t be put-off another day.

Well, I've got good news and bad news. What’ll it be first? Okay, we’ll start with the bad news… Although saving aggressively, early and often is absolutely critical to retiring in style, the unsettling reality is that the mechanical process of saving, though vitally necessary, isn't necessarily enough to catapult you over the retirement finish line. But don't despair; before imagining a bleak future wherein you're old and gray and shivering for warmth beneath a pile of blankets and sitting before the drafty chill of a mostly vacant fireplace while clutching a cold bowl of oatmeal—here’s the good news. Are you ready? Thanks to capitalism’s buoyant long-term record, as clearly demonstrated by well over 80 years of stock market history, it's possible for people of even modest means who have a decent savings ethic and a lengthy investment time horizon to bridge the mighty chasm between what they can comfortably afford to save on a regular basis and what they’ll someday need to retire in style.

To prove that the good news scenario hinted at above isn't just a cruel hoax, we'll analyze the economic choices of three made-to-order retirement crash test dummies. Using fancy manikins to illustrate financial concepts and the ensuing consequences of three vastly different savings strategies will, I think, add a welcome touch of levity to an otherwise dreary and emotionally charged topic. Because of the somewhat whimsical nature of the three-way retirement race that's about to get underway and the fact that each experimental subject is an inanimate object whose long term financial needs (and whether or not they're ultimately satisfied) won't elicit much concern, we can, with near clinical detachment, dispassionately focus on the long-term results of this unorthodox fiscal experiment. The final results, which will slowly manifest over a 40 year period so as to approximate the duration of a career, will enable us to more clearly see the extent to which each crash test dummy's financial strategy pays off. Sit tight; this will be an informative lesson in fiscal physics that you won’t want to miss.

To lay the groundwork for this fanciful simulation, we'll start by defining the respective similarities and differences among our crash test dummies with respect to how they each manage their money. Though they're all equally diligent savers and they consistently set aside equal amounts of money in unison throughout their make-believe careers, we’ll soon see that the amount of wealth each accumulates has surprisingly little to do with how frequently or even how aggressively each saves. Remarkably, it’s what they do with their hard-earned savings that's the single most influential determinant of their future wealth. So that we won’t have to idly wait around for 40 long years for the results of this fiscal experiment to materialize, we’ll take the easy way out. We’ll do this by strapping each of our prosthetic contestants into a fancy electronic chair that, interestingly enough, is the driver's seat of a nicely preserved 1980s Delorean. Shortly thereafter, we’ll flip the switch in the time control room and, presto, dispatch each retirement contestant into the distant past. Borrowing from the storyline to James Cameron’s hit film The Terminator, in a spectacular haze of dazzling lights and costly special effects, our crash test dummies will each miraculously disappear into thin air and rematerialize 40 years ago.  Our intrepid retirement contestants will be born into a world of gainful and blissfully uninterrupted employment.

Our crash test dummies works tirelessly and with machine-like persistence toward the realization of a shared retirement goal: a million bucks. Now, to achieve this, each saves $145 from each and every paycheck they receive throughout their 40 year-long careers. Because dummy # 1 can't stop obsessing over keeping his hard-earned retirement money safe, he stuffs every last dollar into his mattress at home. Dummy # 2, on the other hand, isn’t quite so risk averse; he socks his retirement savings into certificates of deposit that yield rock-steady 4% annualized returns. In stark contrast to dummies # 1 and # 2, however, dummy # 3 is a financial dare devil; he plows his retirement money in a broadly diversified mix of stocks. Although the magnitude of dummy #3’s savings fluctuates dramatically over any one or two year period, this volatility eventually dissipates, producing annual returns of 11.15%. Interestingly, this number wasn’t blindly plucked from out of thin air. According to Ibbotson Associates Inc., a respected market research firm, this lofty rate of return coincides with the stock market’s average yearly performance from 1926 to 2002.

Now that the ground rules for this fiscal experiment have been clearly defined, let’s sit back in the time-control room, kick up our feet, and enjoy a refreshing beverage or two. We'll allow the pages of the calendar to fly by. Time will accelerate on its not-so-merry way, but we'll stop the clock 40 years from the moment that our crash test dummies earn their first paycheck. Of course, calculating the results of this long-term financial experiment will require crunching a few numbers. Since each is paid twice a month, or 24 times a year, a 40 year career yields a whopping total of 960 paychecks; which, when multiplied by $145 (the amount that each saves per paycheck), yields a baseline nest-egg of $139,200.00 for each retirement contestant. Dummy # 1, who misused his savings as glorified mattress stuffing, clearly misses the million dollar savings mark by a country mile. Inching to retirement at this glacial pace, he’d need to work 247 years to stuff his mattress with a million bucks—and this not-so-rosy scenario doesn't take into account inflation’s wealth withering effects. It’s a good thing that a crash test dummy’s plastic parts are sturdily constructed and don't easily break down. Were this not the case, it's possible that dummy # 1 might not reach his retirement savings goal at all. Recent advances in healthcare and rising life expectancies notwithstanding, a flesh-and-blood person may not be so fortunate. What about dummy # 2? Because his money compounds at a considerably faster non-zero clip, he ends up with a lot more money after 40 years: $343,340.00, to be exact. Regrettably, this falls well short of his million dollar savings goal. As you can see, although dummy # 2 easily beats dummy # 1 to the retirement finish line, it will still take him 63 years to cross that eagerly anticipated threshold. Remarkably, if inflation were factored into Dummy # 2’s long-term financial results, the purchasing power of his nest-egg would shrivel to just $163,330. Ouch! How about dummy # 3, that swashbuckling financial daredevil? Certainly, he braved greater volatility in the short-term value of his savings in order to achieve higher long-term returns. But, the million dollar question is: are the stock market’s lofty returns able to propel him to his savings goal? Amazingly, because dummy # 3’s savings grow 11.15% a year, he not only reaches his million dollar savings target, he surpasses it--amazingly, with $2.64 million in tow.

At first glance, Dummy # 3’s outsized fortune seems suspiciously large. One might even argue that the numbers don’t make sense. How can dummy # 3’s 11.15% rate of return, which is almost three times greater than dummy # 2's 4% rate of return, produce nearly 7.7 times more wealth? The glaring asymmetry of these numbers seem punk. Nevertheless, the figures 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 span of time are extraordinary! In fact, the mechanics of compound interest are so remarkable that Albert Einstein called 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 in style and with the purchasing power of a million bucks. 

So, as you can now more clearly see, 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. Although dummy # 1’s mattress-minded ways certainly protected his wealth from the risk of loss, he pays dearly for the illusory peace of mind it provides. Ironically, dummy # 1’s pathological aversion to financial loss is largely responsible for his disastrous long-term economic results. Similarly, though dummy # 2’s retirement savings earn a comparatively higher rate of return, it’s not high enough for him to save a million dollars in 40 years. In stark contrast to the first two dummies, however, dummy # 3’s results are staggering. In his case, it’s as though a financial magician somehow reached into a cavernous top hat, and, with considerable effort, extracted a wheel-borrow full of crisp and neatly stacked hundred dollar bills. What’s not readily apparent in dummy # 3’s case (because 40 years worth of stock market history was conveniently glossed over in the blink-of-an-eye), is that the gut-wrenching volatility that he endured in the stock market was anything but pleasant. To be sure, if this crash test dummy had a real stomach and actual nerves to match, he would’ve lost his cookies—and on numerous occasions. At times, the stock market treated Dummy # 3 so harshly that, were he an actual person subject to emotional whims, he would’ve been sorely tempted to pull the proverbial rip cord and bail out of the stock market altogether. Needless to say, during those dark and difficult times, nobody would have questioned his sanity or thought any less of him for doing just that. Fortunately, dummy # 3's intestinal fortitude and indifference to volatility are generously rewarded.

Now, a few words of caution are in order. Just because a statistical accounting of the stock market's storied history suggests an average annualized return of 11.15% from 1926 to 2002 doesn’t mean that equities will produce similar returns over any future period of time. Nor, for that matter, does it mean that the stock market delivered a return of exactly 11.15% during any 12 month interval during that lengthy 77 year span. Bear in mind, 11.15% is just an average. In other words, for half of those 77 years, the stock market produced returns that were as good or better than the average. The other half, its returns were worse--in some cases considerably worse. Over one or more decades, however, the stock market responds rather favorably to capitalism's buoyant influence and humanity's tireless ingenuity when faced with a profit motive. So, despite its erratic volatility and manic mood swings, over a ten or twenty year period, the price chart of any well-known and widely followed index (i.e., the Dow Jones Industrial Average, Wilshire 5000, or S&P 500) tends to trace a nice smooth upward sloping line. It's worth emphasizing, however, that throughout its long history, the stock market has witnessed many calamitous events. This doleful list includes: the threat of nuclear holocaust; numerous skirmishes and two world wars; a presidential assassination; the great depression, and just about any other disaster 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 time, the stock market has 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 provided outstanding long-term returns, it’s unwise to own just stocks. Why mimic the narrow minded money management philosophies of dummies 1, 2, or 3 when you can combine the best elements of all three? Although dummy # 1’s overly conservative approach to managing his savings ultimately lands him in the poor house, don’t be mislead by his disastrous results. There’s a welcome place for cash in any portfolio. It’s a good idea to keep some handy at all times so that, should markets unexpectedly tank, you can take advantage of the opportunity to buy high-quality cash generating businesses at irrationally discounted prices. Similarly, although slowly plodding investments like bonds and CD’s aren’t very exciting, their slow plodding performance lends a worthwhile measure of stability to the unruly volatility of an 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. Moreover, 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 start saving and you can’t afford to manage your wealth too conservatively. Don’t learn what dummy # 1 and dummy # 2 learned the hard way. When it comes to achieving faraway financial goals, you must think beyond the mattress.