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. There's a perfectly good explanation for this: it's practically impossible for anyone to determine exactly how much wealth it'll take to support a particular standard of living. But take heart, while this may be technically true, there is a clever way of estimating how much money your retirement is likely to cost. Now, the problem with casually slapping a price tag on something as dauntingly huge as retirement is that there are many key variables to consider and countless ways for the delicate financial calculus to go horribly awry. Unless you have a properly calibrated crystal ball that's able to peer into the foggy future and accurately predict inflation, investment returns, the date of one's demise, health care costs and tax rates, there's no telling how much money will be needed to live well in retirement. Throw in wildly variable lifestyle preferences and their associated costs, and it's clear that retirement numbers resemble snowflakes; no two are exactly alike.

Fortunately, when it comes to estimating how much a decent retirement will cost, there’s a simple back-of-the-envelope approach to crunching the numbers that automatically compensates for all of this economic uncertainty. In fact, if you follow the simple multi-step procedure I'm about to outline, you can arrive at a very good estimate of your retirement number. This time and labor intensive process--which I call the retirement price tag estimator--will produce a lifetime savings target that's likely to meet your unique personal requirements. That's the good news. The bad news is that it takes a bit of doing on your part to produce worthwhile results. Start by gathering and organizing 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. The idea is that you want to create a thorough and painstakingly detailed record of your day-to-day, week-to-week and month-to-month spending. Naurally, this will require methodically tracking and tabulating expenditures for everything from housing and transportation to phone and cable bills, groceries, entertainment and restaurants. Now, once you've exhaustively analyzed your spending and have determined how much it costs to support your present standard of living for a year, multiply this grand total by a factor of, say, twenty-five. By all means, if you want to live dangerously (and aren’t terrified by the prospect of running out of money before running out of time) then, by all means, feel free to experiment with a smaller number--though I'd caution against using a multiplier of less than 20.

So long as your outflows don't dramatically change in future years, this monstrous sum is what you should strive to save over the course of your working life in order to enjoy a lofty and largely self-sustaining financial orbit without ever again having to rely on the economic support of an income. Rest assured, when your net worth approaches this lofty magnitude, you'll have your proverbial cake and be able to eat it too. Now, once you've allowed ample time for the enormity of your retirement 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, offers an entertainingly informative yet down-to-earth step-by-step account (this is essential reading for anyone who's interested in exploring this fascinating topic in greater detail) of how to go about sizing-up the nest-egg you'll need to someday drop out of the rat race for good while, at the same time, having enough financial resources to indefinitely support a given lifestyle. Believe-it-or-not, establishing good savings habits and a constructive wealth ethic at an early age is essential to the success of any long-term retirement savings plan. Sacrifice and smart economic planning throughout one's 30s and 40s can, through the magic of compounding returns, make all the difference between merely getting by or living it up decades from now. The takeaway point? Retirement is expensive. So, when it comes to feathering your nest and saving up for your golden years, brace yourself for a high-voltage dose of sticker shock. Even if the prospect of retirement seems absurdly remote right now and the idea of saving for it seems rediculously premature, make no mistake, old age looms menacingly somewhere down the calendar like the financial equivalent of Mt. Everest. For reasons that will be readily apparent a few decades from now, the ongoing work of 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 the lifelong struggle to reach retirement, the unsettling reality is that the ongoing process of regularly saving, though still vitally necessary, may not be enough for you to retire in style many years from now. But don't despair; before resigning yourself to a bleak distant future wherein you're old and gray, shivering for warmth beneath a heap of blankets and sitting before the drafty chill of an empty fireplace clutching a cold bowl of oatmeal—here’s the good news. Are you ready? Thanks to capitalism’s buoyant long-term record, as evidenced by over 80 years of stock market history, it's possible for those with even modest means, a decent savings ethic, and a multi-decade investment time horizon to bridge the yawning gap between what they can comfortably afford to save on a paycheck-to-paycheck basis and what they’ll eventually need to retire in style.

To prove that the good news scenario just alluded to isn't a cruel hoax, we'll analyze the economic choices of three made-to-order retirement crash test dummies. Consider this a whimsical and fun thought experiment. Using mannequins to illustrate financial concepts and then compare side-by-side the long-term economic outcomes resulting from three distinct savings strategies will, I think, add a welcome touch of levity to an otherwise dreary and emotionally charged topic. Because of the fanciful (and hopefully, entertaining) nature of the three-way retirement race that's about to get underway, and since our experimental subjects are inanimate objects whose retirement savings goals (and whether or not they're achieved) won't elicit much concern, we can, with near clinical detachment, dispassionately focus on the outcome of this unorthodox fiscal experiment. The economic results, which will manifest over 40 long years to approximate a real person's working lifespan, will enable us to more clearly see how each crash test dummy's financial habits ultimately pay off. Sit tight; this will be an informative lesson in fiscal physics you won’t want to miss.

To lay the groundwork for this epic financial contest, I'll start by describing the similarities and differences between each crash test dummy with respect to how they handle money and what they do with their long-term savings. They're equally diligent savers, have identical incomes, and, in lockstep with one another, set aside equal amounts of money for retirement. At the risk of prematurely giving away the moral of this captivating story, we’ll soon see that how much each crash test dummy saves at the far end of 40 years has surprisingly little to do with how much they earn. Remarkably, it’s what they do with their hard-earned savings that is the single most important determinant of their future wealth. So that we won’t have to impatiently wait around four decades for the results of this fiscal experiment to materialize, we’ll take the easy way out. We’ll accomplish this by strapping each of our prosthetic retirement contestants into a fancy electronic chair. Shortly thereafter, we’ll flip a switch in the time control room, and, presto, dispatch each intrepid dummy to the distant past. Borrowing from the storyline to James Cameron’s hit film The Terminator, in a spectacular haze of special effects, our crash test dummies will miraculously emerge out of thin air 40 years ago where they'll be indentured to a world of gainful and blissfully uninterrupted employment.

Of course, each crash test dummy works tirelessly and with machine-like persistence toward the realization of a shared goal: a million bucks in retirement capital. Now, to achieve this worthy goal, each saves $145 from each and every paycheck they'll earn throughout their 40 year-long career. Because dummy # 1 is preoccupied with the safety of his money, he stuffs every dollar into his mattress at home. Dummy # 2, who isn’t quite so risk averse, puts his retirement money 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 consistently plows his retirement cash into a diversified mix of stocks. Although the value of dummy #3’s savings fluctuates dramatically over any one-to-five year period, this volatility eventually disappears and produces annual returns of 11.15%. Interestingly, this number wasn’t randomly plucked from out of thin air. According to Ibbotson Associates Inc., a research firm, this rate ot return corresponds to the stock market’s average annual performance from 1926 to 2002.

Now that this fiscal experiment's ground rules 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 be sure to stop the clock exactly 40 years from the day that our crash test dummies first begin to work for a paycheck. Of course, calculating the economic results will require crunching a few numbers. Since each is paid twice a month, or 24 times a year, a 40 year career yields a grand total of 960 paychecks, which, when multiplied by $145 (the dollar amount each saves per paycheck), yields a baseline savings amount of $139,200.00 for each retirement contestant. Dummy # 1, who misused his savings as glorified mattress stuffing, clearly misses his million dollar savings target. Inching to retirement at this sloth-like pace, he’d need to work a total of 247 years to stuff his mattress with a million bucks—and this doesn't even take into account inflation’s pernicious wealth withering effects. It’s a good thing that a crash test dummy’s plastic parts are sturdily constructed and don't quickly wear out. Were this not the case, dummy # 1 wouldn't reach his retirement savings goal at all. Recent advances in healthcare and rising life expectancies notwithstanding, a flesh-and-blood person may not be able to work this long. What about dummy # 2? Because his money grows at a faster non-zero clip, he ends up with a lot more money after 40 years: $343,340.00. Regrettably, dummy # 2 still falls uncomfortably short of his million dollar savings goal. Although dummy # 2 easily beats dummy # 1 to the retirement finish line, it still takes him 63 years to accomplish this feat. Moreover, if inflation were factored into Dummy # 2’s long-term results, the purchasing power of his nest-egg would shrivel to just $163,330. Ouch! How about dummy # 3, that swashbuckling yahoo? Certainly, he endured greater volatility in the short-term value of his savings to achieve greater long-term returns. But, the million dollar question is: are the stock market’s superior returns high enough to propel him to his savings goal? Amazingly, because dummy # 3’s savings compound in value at an impressive 11.15% annualized clip, his bank account not only reaches the million dollar threshold, it surpasses it; and with $2.64 million to spare.

At first glance, Dummy # 3’s outsized fortune seems suspiciously large. One might rightly argue that the numbers don’t make sense. After all, how can dummy # 3’s 11.15% annual rate of return, which is roughly three times greater than dummy # 2's 4% rate of return, go on to produce nearly 7.7 times more wealth over a four decade span? Admittedly, the asymmetry of the economic results may, to the uninformed observer, be suspicious. Nevertheless, the figures have been triple-checked and they're correct. The moral of this story is that the wealth-building power of higher compounding returns acting over a multi-decade period are extraordinary! In fact, the mechanics of compound interest are so remarkable 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 retires in style with the purchasing power of a million bucks. 

So, as you can 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 fortune 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 higher rate of return, it’s not nearly enough to enable him to amass a million bucks in 40 years. Unlike dummies one and two, however, dummy # 3’s results are positively staggering. In his case, it’s as though a financial magician reached into a cavernous top hat, and, with considerable effort, extracted a wheel-borrow brimming with 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 he suffered in the stock market was anything but pleasant. To be sure, if dummy # 3 had a real stomach and actual nerves to match, he surely would’ve lost his cookies—and on many occasions. At times, the stock market treated Dummy # 3 so harshly that, were he an actual person subject to emotional whims and reflexive knee-jerk reactions, he would’ve been sorely tempted to pull the proverbial rip cord and bail out of the stock market altogether. Needless to say, in those dark and difficult times, nobody would have questioned his sanity or the wisdom of his judgement for doing just that. Fortunately, we see that dummy # 3's 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 overall performance from 1926 to 2002 yields an average annualized return of 11.15% 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 actually delivered a return of 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 posted returns that were better than the 11.15% average. For the other half, its returns were worse--in some cases considerably worse. Over one or more decades, however, the stock market responds favorably to capitalism's influence and humanity's boundless ingenuity when faced with a profit motive. So, despite its erratic volatility and violent mood swings, over a multi-decade period, the price chart of any well-known and closely followed index (the Dow Jones Industrial Average, Wilshire 5000 and S&P 500) tends to trace a nice smooth upward sloping line. It's worth emphasizing, though, that during its long and rocky history the stock market has witnessed many calamities, including: the threat of nuclear holocaust; 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 periodic systemic shocks, the stock market has risen seven out of every ten years going all the way back to 1928. Interestingly, in this time, the stock market has experienced 57 up and 24 down years. You won't find these odds, or the prospect of recurring dividends, in Vegas. The upshot is that the longer one remains invested in the stock market, the less risky investing in it becomes.

Paradoxically, although stocks have generated outstanding long-term returns, it’s unwise to own just stocks. Why mimic the overly rigid financial mindsets of dummies 1, 2, or 3 when you can elegantly combine the best elements of all three? Though dummy # 1’s overly cautious and conservative approach to managing his savings ultimately lands him in the poor house, don’t be mislead by his disastrous results. There’s a place for cash in any long-term savings portfolio. It’s a good idea to keep some handy at all times so that, should the stock market tank, you can take advantage of the opportunity to buy high-quality cash generating businesses at irrationally depressed prices. Similarly, although the slow plodding growth of investments like bonds aren’t thrilling, their steady performance brings a worthwhile element of stability to help offset the gut-churning 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 and to stick with a plan. Luckily, 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've got to think beyond the mattress.