The Retirement Perspective

Lois had an interesting question about retirement:

I asked if, by calculating our monthly expenses, we could multiply that by 200, and if that would be enough to retire. So, if one’s expenses were about $24,000 a year, if having $480,000 would be enough. And you said – rightly so – that this figure doesn’t include inflation, and that a safer amount would be close to 2 million! That’s a lot of money, and I must agree with one of the readers who said very, very few people can afford to save that amount during a lifetime.

I strongly disagree with the statement that very, very few people can afford to save that amount during a lifetime. The combined powers of compound interest and inflation will easily push a person’s investment level higher and higher. Many young people today, if they get started, will have millions in the bank when they retire, even if they don’t have a top-paying job.

I’ll use Jeff as my example. Let’s say Jeff is 25 years old and currently makes $35,000 a year. He wants to retire at age 65. He decides to put 10% of his income away into a 401(k), earning a 5% match from his employer. If you assume he gets a 9% annual return on his investment over the long haul, that inflation is at 4.5% annually over that period, and that the only raises he gets are cost of living raises to match inflation, he’ll have $2.018 million in his account on his 65th birthday. There’s nothing unrealistic about any of the assumptions here.

The problem is that from today’s perspective, $2 million seems like an enormous amount of money. And it is, in today’s dollars.

Comparing the Past, Present, and Future Dollars

Comparing 1968 to 2008

But let’s roll back the clock forty years and see how things have changed. I’ll use the CPI-A for my historical inflation numbers.

The CPI-A is a number you can use to compare prices from one year to another It takes into account the changing prices of goods and services and comes up with a number that expresses that difference. For example, on January 1, 2006, the CPI-A was at 199.4, while on January 1, 2008, the CPI-A was at 212.516. This means that the goods you could buy for $199.40 on January 1, 2006 would cost you $212.52 on January 1, 2008.

Now, let’s say Jeff started saving in June 1968, when the CPI-A was 34.9. Then, he retired in June 2008, when the CPI-A was 219.181. This means that every $34.90 Jeff earned in 1968 was worth $219.18 in 2008.

Now, let’s translate those numbers a bit. Let’s say Jeff had $2 million in 2008 dollars. In 1968 dollars, it’s only $318,459.

On the flip side, let’s look at investments. On January 2, 1968, the Dow Jones Industrial Average was at 906.84. On December 31, 2007, forty years later, it stood at 13,264.82.

That means, in order to have $2 million in 2008, you would have had to only put $136,728.58 into the Dow Jones blue chips in 1968

Comparing 2008 to 2048

Now, let’s say you’ve decided that you need $24,000 in today’s money as living expenses when you retire in 40 years. Let’s also assume the stock market and the CPI-A change remain the same over the next forty years as they were over the last forty (they won’t be, but we can use them as a yardstick).

First of all, your annual $24,000 today would have to be $150,276.19 in 2048. That would actually be $12,560.52 a month in that timeframe. Using Lois’s “monthly amount times 200” equation, she’d actually have to have $2.5 million in the bank then.

If Lois set her retirement goal at $480,000, she would be starving in 2048.

But she’s forgetting that compound interest works more strongly in her favor overall. A person today, filing singly, who has $24,000 in income that they can spend actually has a salary of about $30,000 before income taxes.

So, let’s say Lois is actually just trying to keep her current standard of living. She’s 25, earns about $30,000 a year, and never has any interest in climbing the corporate ladder and earning more – she’ll just earn cost-of-living raises for the rest of her career (ideally, this isn’t true, but we’ll make a “worst case” scenario for Lois). Her employer matches 1% for every 2% Lois contributes to her retirement account.

All Lois has to contribute to her 401(k) to reach her goal (using the assumptions above) is 15% of her salary. That’s assuming no performance-based raises ever, no promotions ever, and no job changes ever. If Lois commits herself to building a career and gets a few promotions along the way, her contributions can easily be lower than that.

$2.5 million is a completely realistic retirement goal for a young person only earning $30,000 a year They’re helped along by the power of compound interest.

Applying this Principle to Your Retirement Dollars

Is Lois’s “200 Times Monthly” a good thumbnail? It’s only a good thumbnail if you’re starting off with your estimated monthly costs in retirement. Even then, it’s a bit on the risky side, as it will require solid returns on the investments to keep up with the spending.

There are two problems with using such easy thumbnails:

The first one is math based. If you figure everything in today’s dollars, you won’t make ends meet later on. You’ll have to estimate what you expect to spend then. Doing that in Excel is easy, actually. If you believe that inflation will be at 4.5% from here until retirement, enter something like =2400*1.045^25 where 25 is the number of years you think you’re away from retirement and $2,400 is the amount you expect you’ll need in today’s dollars each month (for those curious, it’s $7,213.04).

If you then take that number and multiply it by 200, then you’re starting to get a reasonable retirement figure. I think, actually, that 200 is a bit low, as it assumes a 6% annual return in retirement just to break even. Try using 240 (which assumes a 5% annual return) or 300 (which assumes a 4% annual return) for more safe and realistic thumbnail estimates.

The second one is psychological. The numbers you’ll come up with doing this math seem frighteningly large. Most people then react by ignoring the numbers, arguing that they’re false, or using some other form of psychological crutch to make the number seem more reasonable. But it already is reasonable. It’s important to remember that a 1968 dollar is worth $6.28 in today’s dollars. If your old man was earning $10 an hour at the factory in 1968, that’s like earning $62.80 today. In reverse, a dollar today can only buy what $0.16 bought in 1968. These trends will be (roughly) the same into the future. A dollar today will likely be worth somewhere between $5 and $10 in 2048.

It’s for those two reasons that I don’t find a “target” for retirement to be too useful, especially early on. It can play psychological tricks on you and it can trip you up if you’re not strong on the math.

Instead, just stick to a strong savings plan from your first day at work. Don’t even think about it – just start putting away 10% of your salary either into a 401(k) or a Roth IRA (or some combination thereof). If you do that and work hard at your career, your retirement will be in fine shape.