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, very few can confidently assess their overall level of preparedness. There’s a perfectly sensible explanation for this: it’s practically impossible for anyone to determine how much money it’ll take to support a given standard of living indefinitely. But take heart, the good news is that there’s a clever way of estimating how much money the retirement lifestyle you’ve had your eye on will cost. Now, the problem with putting a price tag on something as overwhelming as retirement is that there are many changing variables to consider and countless ways for the messy economic calculus to go horribly awry. Unless you’ve got a properly calibrated crystal ball that can peer deep into the foggy faraway future and accurately discern dynamic variables like inflation, future investment returns, personal longevity, the precise trajectory of health care costs and tax rates, there’s just no telling how much money you’ll need to live well in retirement. Throw in wildly variable living standards and the long-term cost of supporting them, and it’s jarringly apparent that retirement numbers resemble snowflakes; no two are exactly alike.

Fortunately, when it comes to eliminating a lot of the uncertainty in guesstimating how much a dignified retirement will cost, there’s a simple back-of-the-envelope approach to crunching the numbers that dispels much of the economic confusion. In fact, if you follow the simple multi-step procedure I’m about to outline, you’ll have a very accurate and reliable estimate of your retirement number. This time and labor intensive process–which I call the 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 considerable effort on your part to produce worthwhile results. 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 analyze. The idea is that you want to create a thorough and excruciatingly detailed record of your day-to-day, week-to-week, and month-to-month spending behavior. Naturally, this means carefully tracking and tabulating expenditures on everything from housing and transportation to phone and cable bills, groceries, entertainment and, of course, restaurants. Once you’ve correctly quantified and categorized your personal spending and have an all-in-one figure representing much it costs to support your standard of living for a year, multiply the grand total by a factor of, say, twenty-five. By all means, if you want to live dangerously (and aren’t terribly concerned about the possibility 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 inflows and outflows don’t dramatically change in future years, this monstrous sum is what you’ll need to squirrel away over the course of your working life to achieve a lofty and largely self-sustaining financial orbit without ever again having to rely on the economic support of a paycheck. Rest assured, when your net-worth approaches this impressive magnitude, you’ll have your proverbial cake and be able to eat it too. Once you’ve allowed ample time for the enormity of your thoughtfully calculated retirement savings target 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 detailed yet refreshingly down-to-earth step-by-step overview (this is essential reading for anyone who’s interested in more closely exploring this worthwhile topic) of how to size-up the nest-egg you’ll need to drop out of the rat race and figure out how strong a balance sheet it’ll take to indefinitely support a given lifestyle. Believe-it-or-not, establishing good savings habits and a constructive wealth ethic early on in life is essential to the success of this process. Sacrifice and shrewd 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 many decades from now. The takeaway point? Retirement is expensive. So, when it comes to feathering your nest and saving for the eventuality of your golden years, brace yourself for a sobering dose of high-voltage sticker shock. Even if the prospect of retirement seems absurdly remote and the idea of saving for it now seems ridiculously premature, make no mistake, old age looms menacingly somewhere down the calendar like the financial equivalent of Mt. Everest. For reasons that’ll be painfully apparent a half century or so from now, the ongoing work of planning and saving for it shouldn’t be delayed 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 necessary to the lifelong struggle to reach retirement, the unsettling reality is that regularly saving may not, by itself, be enough for you to accumulate enough wealth to retire comfortably. But don’t despair; before resigning yourself to a bleak and incredibly remote future wherein you’re old and gray, shivering for warmth beneath a pile of blankets and lounging before the drafty chill of an empty fireplace while clutching a bowl of cold oatmeal—here’s the good news. Are you ready? Thanks to capitalism’s buoyant long-term record (as shown by 80+ years of stock market history) it’s possible for individuals with modest means, a decent savings ethic, and a multi-decade investment time horizon to bridge the yawning divide between what they can comfortably afford to save on a paycheck-to-paycheck basis and what they’ll one day need to retire in style.

To prove that the good news scenario just alluded to isn’t a cruel hoax, we’ll analyze and trace the economic choices of three made-to-order retirement crash test dummies. Consider this unorthodox narrative a fun thought experiment. Using fancy mannequins to illustrate important financial concepts and compare side-by-side the long-term results of three different and distinct saving and retirement funding approaches will, in theory, bring a welcome touch of levity to an otherwise dreary and emotionally charged topic. Because of the whimsical (and hopefully, entertaining) nature of the three-way retirement race that’s about to get underway, and since the long-term welfare of our experimental subjects and whether or not they reach their retirement savings goals is unlikely to elicit much concern (after all, they’re inanimate objects and, as such, are ideally suited to weather even the harshest of future economic conditions) we can, with near clinical detachment, dispassionately focus on the outcome of this fascinating fiscal experiment. The economic results, which will slowly and progressively manifest over 40 long years so as to simulate a real person’s professional tenure, will enable us to more clearly see how each crash test dummy’s financial strategy pays off. Sit tight; this will be an informative lesson in fiscal physics you won’t want to miss.

To lay the groundwork for this three-way retirement race, let’s begin by clearly establishing the respective similarities and differences between each of the crash test dummies in how they manage their money and what they do with their long-term savings. Luckily, they’re all equally diligent savers, have identical incomes and, in lockstep, set aside equal amounts of money for their golden years. At the risk of prematurely giving away the moral of this riveting story, we’ll soon see that how much money each crash test dummy sets aside each paycheck will, at the far end of 40 years, have surprisingly little influence in determining the magnitude of their end of career nest-egg. Remarkably, it’s what they do with their hard-earned money that’s the single biggest factor in 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 intrepid prosthetic contestants into a fancy electronic chair. Shortly thereafter, we’ll flip a switch in the time control room and, presto, dispatch each economic crash test 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 experimental subjects will miraculously emerge from out of thin air 40 years ago and will be indentured to a world of gainful and blissfully uninterrupted employment.

Of course, each crash test dummy works tirelessly and with grim machine-like determination toward the realization of a shared goal: a million bucks in retirement capital. Now, to achieve this lofty financial goal, each saves $145 from each and every paycheck they’ll earn over the course of their 40 year-long careers. Because dummy # 1 is preoccupied with the safety of his money, he dutifully stuffs every saved 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. Unlike dummies # 1 and # 2, however, dummy # 3 is something of a financial dare devil; he consistently plows his retirement cash into a broadly diversified mix of stocks. Although the value of dummy #3’s savings seems to violently fluctuate over any one-to-five year period, this volatility eventually disappears and produces a notably higher annual return of 11.15%. Interestingly, this number wasn’t blindly plucked from out of thin air. According to Ibbotson Associates Inc., a research firm, this rate of return corresponds to the stock market’s average annual return from 1926 to 2002.

Now that the ground rules for this far-fetched 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 be sure to stop the clock exactly 40 years from the day that our crash test dummies first begin to earn a paycheck. Of course, calculating the results will require crunching the numbers. Since each is paid twice a month, or 24 times a year, a 40 year career produces a whopping lifetime total of 960 paychecks, which, when multiplied by $145 (remember, this is the dollar amount 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 his million dollar savings target. Inching to retirement at this sloth-like pace, I estimate that he’d need to work a not-so-grand total of 247 years before he’d have enough moolah to stuff his mattress with a million bucks—and this hypothetical doesn’t even take into account inflation’s sinister 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, dummy # 1 wouldn’t reach his retirement savings goal at all. Recent advances in healthcare and rising life expectancies notwithstanding, however, an actual flesh-and-blood person may be unable to withstand such a lengthy career. What about dummy # 2? Because his money grows at a considerably faster non-zero clip, he ends up with a lot more money after 40 years: $343,340.00. Regrettably, dummy # 2 still falls well short of his million dollar savings target. Although dummy # 2 easily beats dummy # 1 to the retirement finish line, it still takes him 63 years to do so. Moreover, if inflation were factored into dummy # 2’s long-term economic results, the purchasing power of his nest-egg would dwindle to just $163,330. Ouch! How about dummy # 3, that swashbuckling financial yahoo? Certainly, he endured greater volatility in the short-term value of his savings to achieve significantly higher long-term returns. But, the million dollar question is: are the stock market’s returns great enough to propel him to his savings goal within a biologically normal 40 year career span? Amazingly, because dummy # 3’s savings compound at a far more impressive 11.15% annualized clip, his bank account not only reaches the million dollar threshold, it surpasses it; amazingly, with $2.64 million to spare.

At first glance, dummy # 3’s outsized fortune seems suspiciously large. One might rightly argue that these 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, produce nearly 7.7 times more wealth over four decades? Admittedly, the asymmetry of their economic results may, to the uninformed observer, look suspicious. Nevertheless, the figures have been triple-checked and they’re all 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 equivalent 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 necessarily enough. Although dummy # 1’s mattress-minded ways certainly protected his fortune from loss, he paid dearly for the illusory peace of mind it provided. 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 significantly higher rate of return, it’s not nearly high enough for him to amass a million bucks in 40 years. Unlike dummies one and two, however, dummy # 3’s results are positively astounding. 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 tightly bundled 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 endured 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 of a sane person, 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 judgement for doing just that. Fortunately, we see that dummy # 3’s patience 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 performance from 1926 to 2002 yields an average annualized return of 11.15% doesn’t mean that equities can be safely trusted to produce similar returns over any future span of time. Nor, for that matter, does it mean that the stock market actually delivered a return of 11.15% during any 12 month period during that lengthy 77 year interval. 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 better than the 11.15% average. For the other half, it posted annual returns that were worse–in some cases much worse. Over one or more decades, however, the stock market tends to respond favorably to capitalism’s buoyant influence and humanity’s boundless ingenuity when faced with a profit motive. So, despite its erratic short-term volatility and violent mood swings, over any 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 are notable examples) 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 a calamity, 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 recurring 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. To be sure, 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 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 in retirement, 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 snap up high-quality cash generating businesses at irrationally depressed prices. Similarly, although the slow plodding performance of investments like bonds aren’t exactly thrilling, their steady performance brings a worthwhile measure of stability to partly counteract 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 informed choices and have 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 dummies one or two learned the hard way. When it comes to achieving faraway financial goals, it pays to think beyond the mattress.


  1. Wow, amazing blog layout! How long have you been blogging for?
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    • bpmedlin says:

      Thank you for those kind words. This has been an ongoing labor of love. I could tweak, fine-tune and polish article content forever–and enjoy doing it… Someday, it’ll shine. How did you come across this site?

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