By Henry K. (Bud) Hebeler

6/9/05

When I was young, I got some valuable financial tips from my father. One of these was to always save at least 10% of my income and then some. Another was to NOT try to keep up with the Jones. These two principles have helped make my current retirement life a lot easier.

Modern young people are severely tempted to keep up with the Jones. They see people of like age all around them with the latest electronic toys, large houses, new vehicles, etc. In order to get these things, they make lots of purchases with credit cards. Little do they realize what this is costing them, not only in the near term, but also the long term.

For example, let’s suppose that they want to buy something that now costs $1,000. If they saved $180 a year for five years before this, they would have invested only 5 x $180, or $900. At the end of five years these savings at 5% return on investments would have compounded to $1,000 so that they could then buy the item for cash.

But keeping up with the Jones requires that they use their credit card instead. Let’s assume that they pay off their credit card debt in five years of equal payments. That $1,000 item will cost them $1,250 at 8% interest, $1,400 at 12% interest, or $1,600 if borrow at 18%. Think of it. Every item that they buy on credit and pay for over five years is costing 39% more at 8% interest, 56% more at 12% interest, or 78% more at 18% interest. Ouch!!!

Next think about the future. The person paying 12% credit card interest paid $500 more than the person who saved the money in advance. Suppose that $500 was invested in a balanced fund that averaged about 8% return. That $500 would grow to over $5,000 in thirty years (perhaps when retire) or $23,000 in fifty years (perhaps in the middle of retirement) or $109,000 in seventy years (when nursing home care might be necessary). Investing in a stock index fund might give over $11,000 in thirty years, $92,000 in fifty years, or $744,000 in seventy years! All of this is lost because of trying to keep up with the Jones.

The flip side of the coin is that all of these savings won’t buy as much as you might imagine. With 3% inflation, every $1,000 would be worth approximately $400 in thirty years, $200 in fifty years, and $100 in seventy years. Inflation is everyone’s enemy and means that we have to save even more to compensate.

The current generation is saving very little for retirement. The average for the U.S. has come down from its historical 10% to about 2% of disposable income. Perhaps people are counting on Social Security and Medicare to provide most of their assistance. That’s unlikely unless they will be willing to live like paupers. Social Security was originally intended to provide about 40% of the retirement income for the average person. The rest was supposed to come from pensions and personal savings.

Pensions are rapidly disappearing for a number of reasons including lack of portability, employer costs, trust solvency, and the current trend to get people to save for themselves using plans such as a 401(k), 403(b), IRA, etc. However, it’s not easy to save enough for retirement with these plans. Any projection requires tortuous assumptions that are highly unlikely to be precise, but using the common assumptions of 8% pre retirement returns and 7% post retirement returns, we’ll try to find how much you would have to save in each of four decades to replace 60% of a young person’s income. To complete the projection we’ll assume 30 years of retirement and that both pre retirement wages and inflation grow at 4%. (It’s common to assume 3% inflation, but excluding the great depression, lengthy periods have had inflation above 4%.)

To replace 60% of current income, you would need to save 10% in years 1 – 10, 15% in years 11-20, 20% in years 21-30, and 25% in years 31-40. That would take a 25 year old up to age 65.

To illustrate, if a twenty five year old earned $30,000 and saved $3,000 and followed the savings percentages described, in the last year of work the wage would grow to $144,000 and the new amount to save would be 25% of that, or $36,000. At retirement, the accumulated savings would support an annual withdrawal of 60% of $144,000 or $86,400. However, because of inflation, that withdrawal would be worth only 60% of the current $30,000 income, that is, $18,000 in today’s dollar values.

Of course savings could be smaller percentages if wages grew much faster than inflation, but the problem here is that wage growth increases the expectation of what is needed for retirement. It’s the Jones again.

Saving is not for the weak. You must be able to say, "No" and mean it. Here are some possible No candidates:

Anything that comes into your house on a wire or with radiation.

Anything that has a battery, chips, or motor.

Anything that has fur or feathers.

Anything with a prominent label.

Anything you can borrow instead.

Anything that requires credit.

So you say, you’ve already cut these kind of things to the bone. Here are some other possibilities:

Minimize insurance costs.

Get a second (or third) job.

Reduce the number of wheels.

Share quarters or rent out a room.

Downsize or relocate.

The best way to save is with payroll deductions, especially if your employer has a savings plan with matching funds. (Next best are usually Roths and IRAs.) Anyone who turns down free matching money from an employer is making a huge mistake.

When you are young, you have a great advantage both with regard to reducing spending and increasing savings. But the greatest advantage of all is that you have years for those early savings to compound into the kind of savings that you’ll need for an attractive retirement—then you’re likely to do better than the Jones.

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