“You can tell your money where to go or you can wonder where it went.” – Dave Ramsey
We have been in a series exploring the myriad of risks we all face when planning and saving for retirement. The term risk is somewhat nebulous as it means a variety of different things to different people. Our goal in this series is to identify the wide variety of risks we all face when it comes to our financial success and ultimately lay the groundwork for how to manage those risks in accordance with our own specific vulnerabilities. When we talk about financial risk most of our us jump straight to the potential for catastrophic events such as a stock market collapse, being laid off at work, or incurring significant medical expenses. But today we’re going to take a step back and discuss a more subversive risk that can (and does) impact nearly all of us – the risk of not saving enough money.
Inadequate savings might not seem like a tangible risk at first. After all, it’s not something that happens to us per se, and there isn’t a specific point in time at which it occurs. It’s hard to identify because we don’t see it as something being taken from us. Have you ever heard the phrase “you don’t know what you’ve got till it’s gone”? Well in this case you don’t know what’s gone because you never had it in the first place. Failing to save is a risk of omission, an opportunity cost that can slowly and quietly erode a financial plan over long periods of time. So how do we address this risk? It’s all starts with simply not spending all our money.
The bedrock of all good financial decision making is the discipline of budgeting, something that unfortunately is not high on many American’s priority list. A recent Gallup poll showed that only 32% of Americans live on a budget, meaning that over two-thirds of our population doesn’t have a good grasp on where their money is going every month. Maybe American’s are just following the example laid out by our elected officials in Congress who haven’t been able to pass a budget since 2009…then again, maybe Congress is just doing a good job representing their constituents (chicken or the egg?).
This is a serious problem, as budgeting is one of the most important financial disciplines any of us can develop. As discussed in a previous Insight, budgeting gives us vision into where each and every dollar is going on a monthly basis. This vision creates real-time awareness which leads to better spending decisions.
Simply put, knowledge is power, and those of us who budget know more about where our money is going than those of us who don’t. This leads to more control, less waste and an increase in financial freedom. That’s right…while many would consider a budget to be restrictive, it is actually quite freeing because it takes the guesswork out of spending decisions and provides a foundation for systematically building out savings and investments.
Put another way, the discipline of budgeting creates clearer vision, and clearer vision leads to proper action. The mind becomes trained over time to recognize how that appetizer and extra drink adds to the final bill at the restaurant, how the true cost of that new SUV includes interest, insurance, registration and increased fuel consumption, and how that new piece of furniture affects how much you can afford to spend on that upcoming vacation. Purchases, both large and small, move from being haphazard and compulsive to fitting within a clearly defined plan. Spending, as a result, becomes more intentional and (ironically) more enjoyable.
Budgeting is how we proactively live within our means, or “act our wage” as some might put it. This is a necessary first step towards saving enough money to meet financial goals. Once the routine of budgeting has been established, decisions must then be made as to the timing and quantity of savings that will be socked away for various long-term financial goals. The general rule of thumb is to start as early as possible and save as much as possible. While this might seem obvious, the miracle of compound interest really needs to be seen to be believed. Let’s look at three different savings comparisons to illustrate my point.
In scenario 1 below, we start by comparing the paths taken by two savers, Elliott and David. In this illustration we assume that all savings are invested and grow at 10% per year. Elliott starts saving $2,500/year at the age of 25 while David starts saving $3,333/year at the age of 35. By age 64, both individuals will have saved exactly $100,000. Because of this fact, you might think that they should end up with relatively similar amounts of money at retirement age, but Elliott’s early start results in an ending portfolio value that is over twice the size of David’s. This incredible difference did not come from socking away more money but resulted solely from starting the compounding clock ten years earlier.
We can further illustrate the time value of money in a second example. Using the same timeline and growth rates as our first example, let’s now assume Elliott saves $2,500/year for only ten years and then stops saving. He has now saved only $25,000 to David’s $100,000, yet at retirement age he still ends up with nearly $150,000 more in his retirement portfolio. This is truly incredible.
In this last scenario, we take the timing of savings out of the equation and simply look at the impact of saving more money every year. Using the same growth rate as before (10%), let’s now assume both Elliott and David start saving at age 25, but Elliott puts away an extra $500/year more than David does. Over the course of 40 years the cumulative difference in dollars saved is only $20,000 ($100,000 for Elliott and $80,000 for David), but the ending portfolio values differ by over $220,000 – again due exclusively to the miracle of compounding.
These examples illustrate why Albert Einstein considered compound interest to be the eighth wonder of the world. The illustrations reflect the enormous impact that the timing and quantity of savings can have on our long-term financial outcomes. While great rates of return and unexpected financial windfalls can also have an enormous impact, the prudent approach is to assume our savings will need to do the bulk of the heavy lifting, so starting early and being intentional with our savings are key.
According to Federal Reserve data the median value of retirement saves for families nearing retirement age is just barely over $100,000. This is far lower than it should be, and it’s no surprise that the Employee Benefit Research Institute reports that only 18% of US workers are confident that they’ll be financially secure in their golden years. We want to be a change agent for our clients, and while there are a number of different ways in which we’ll work towards better than average outcomes it will always start with the simple task of establishing prudent spending and savings habits. Let’s all start telling our money where to go rather than wondering where it went; in doing so we’ll be reducing the risk of inadequate savings and increasing the probability of meeting our long-term financial goals.
NOTE: There are a number of great budgeting tools available on the market. We have personally used both Mvelopes and eMoney Advisor, which is offered to our clients as part of our financial planning package.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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