It is well known that an investor’s best friend is time. Many investors that are approaching retirement frequently wish that they had just started saving earlier, which in many cases would have afforded them the ability to retire much earlier than they now plan. According to a recent Wall Street Journal article, nearly two-thirds of American workers between the ages of 45-60 now anticipate delaying their prior retirement plans. Much of this is due to recent weak investment returns, but much of it may be due to the fact that they didn’t begin saving for retirement early on in their careers.
By getting an early start on building your investments in your career you stretch out your investment horizon. This allows you to achieve a return that approaches long term historical averages (as opposed to short investment horizons where asset returns are more volatile). It also allows for compounded returns on your investment – which is one of the most powerful tools an investor can have. This basically means you are receiving a return on your prior investment returns, and as you stretch out the number of years you are investing then the compounding power continues to grow.
Let’s look at a quick example of two young professionals to see the benefits of extending your investment horizon:
- At age 25 both professionals have a starting salary of $50,000
- Their employer provides a 5% matching 401(k) contribution
- Each of them receives an average raise of 4% per year – slightly above inflation due to continued career advances and post graduate studies
- Both will choose a 100% equity allocation due to their long term investment horizons, and over their career they receive a 9.8% annual compounded investment return (based on Ibbotson data of large company stock returns from 1926-2011)
The only difference between these two will be that one chose to immediately begin participating in the 401(k) plan with a 10% salary deferral. The other chose to wait just 5 years until they were 30 years old to begin a 10% salary deferral. Both continued saving until they were 65 years old, and stuck with a 100% equity allocation over the entire investment period. The difference based on these assumptions: Almost $1.42 million. Over a period of those first 5 years the salary deferrals for the smart investor was just $27,000, but employer matches and compounding investment return power led to this massive difference in their 401(k) balance as they approached retirement.
For many of you nearing retirement this piece isn’t helpful since time travel is still in the works. But, you likely have children or younger relatives who would really appreciate it if you helped them get on the right path. Maybe they won’t appreciate it now, but in 30-40 years when they have developed sizable wealth then you will certainly be their favorite relative.
Reach out to your advisor and we will be glad to review your retirement options at work as well as those of your younger relatives.
Travis Boyer, CFA