Many investors will underestimate the power of compounding and not start an adequate savings program until much later. In fact, the average age for people starting an active retirement savings program is between 35 and 40 years, which has already wiped away plenty of compounding potential. To illustrate this point, consider an investment goal of $1,000,000 by age 60...
Starting at 20
For younger investors looking to save $1 million, they can take a fairly low risk approach and earn an average 5% for the next thirty five years. Their monthly contribution would be approximately $880.21. Without increasing their contributions over the next thirty five years, this 20 year old will have saved and earned $1 million dollars.
For younger investors looking to save $1 million, they can take a fairly low risk approach and earn an average 5% for the next thirty five years. Their monthly contribution would be approximately $880.21. Without increasing their contributions over the next thirty five years, this 20 year old will have saved and earned $1 million dollars.
Starting at 40
If that same 20 year old waits until age 40 to get started, there are several difficulties. By wasting 15 years of compounded growth, the new saver at 40 would only save $361,796 if they kept their contribution of $880.21. To find $1 million waiting for them at 60, the 40 year old must save $2,432.89 on a monthly basis. That assumes the same risk level and annual rate of return of 5%.
If that same 20 year old waits until age 40 to get started, there are several difficulties. By wasting 15 years of compounded growth, the new saver at 40 would only save $361,796 if they kept their contribution of $880.21. To find $1 million waiting for them at 60, the 40 year old must save $2,432.89 on a monthly basis. That assumes the same risk level and annual rate of return of 5%.
Alternatives
Understandably, saving more than $2,400 every month is not easily accomplished. For many, this could represent half of the entire household income on an after-tax basis. However, that does not mean that both earners (or even single earners) need to get two or three jobs to save $1 million.
Understandably, saving more than $2,400 every month is not easily accomplished. For many, this could represent half of the entire household income on an after-tax basis. However, that does not mean that both earners (or even single earners) need to get two or three jobs to save $1 million.
One alternative is increasing one's risk profile in an attempt to earn greater returns. In order to stay at the $880.21 per month contribution, the investor's risk will need to increase considerably to allow for a 13% annual compounded rate of return. Not entirely impossible, but such returns will require considerably greater risk tolerance as well as regular monitoring by the investor to ensure the right risks are being taken (e.g. bonds instead of stocks, international equities instead of domestic, etc.). Again, not quite impossible, but time consuming.
A better alternative would be increase one's contributions, say by 50% to $1,320.32 as well as increase one's risk tolerance. To reach $1 million by making such contributions, investors will need to earn an annualized compounded return of 10%. Yes, it is much more aggressive than the 5% that the 20 year old would have to achieve, but it is more realizable than 13%.
Of course, as a saver ages, earnings typically increase. A 50% increase to one's monthly contributions may not be all that difficult to swallow for some. As well, risk and return relationships are variable, meaning that some years might see 10% from a relatively safe investment while others will see 5% as a great return from a riskier investment.
To get a better understanding of how much one needs to save for retirement, it is always advisable to speak with a financial planning professional.
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