What do you want your life to look like when you’re old?
It’s not a question many people like to ask, especially when they’re young and just beginning their adult lives. And while it is the case that you are likely to be working for many decades before you eventually exit the working world, that retirement will not be so sweet if you do not take the time and effort to consciously plan for it when you’re young.
If you’re a member of Gen Z or possibly even a young millennial, you probably have parents that are now nearing their retirement, if they haven’t started it already. What you need to understand upfront is that retirement for them is very unlikely to look the same way for you, decades from now.
Social Security
Social Security is the term used for the federal government’s Old-Age, Survivors, and Disability Insurance program (OASDI). The original legislation was passed in 1935 and signed into law by President Franklin D. Roosevelt. For decades, the number of program beneficiaries was relatively small compared with the number of workers who were paying into it. For example, there were 16 workers for every 1 retiree in 1950. That ratio continued to dwindle as births decreased and the life expectancy continued to rise. Since 2010, the ratio has remained under 3:1 and continues to drop without any sign of reversing itself.
The current use of the program is unsustainable. Under the most recent projections, Social Security’s primary trust fund is expected to go insolvent by 2035, just over a decade from today. By that time, all beneficiaries will receive close to a 20% cut in their benefit payments. Even if the government raises more revenue for it via a higher FICA tax rate, it will likely still have to cut benefits to some degree in order to regain program solvency.
Why am I telling you all of this? Because the vast majority of today’s retirees depend on Social Security to fund at least a portion of their retirement. For many, that is all they depend on. Based on its current projected path, anyone under the age of 50 today should expect to receive reduced benefits by the time they retire. I suggest anyone under 40 to not plan on receiving retirement benefits from the SSA at all, given its rocky future. In truth, the program is all but guaranteed to remain in place long past 2035, but by the time today’s youths enter retirement, it will likely be a shell of its former self.
This means you need to plan more for your own retirement in a way that previous generations did not have to. In all likelihood, you do not work in a field that provides a defined-benefit plan, or pension plan, which guarantees a certain amount of income, often as a formula for your salary and years of service to the organization. If your job does not provide you with a pension, then you should next seek out a contribution plan instead. There are two main types of contribution plans available today: the 401(k) and the 403(b).
Start Small
The titles 401(k) and 403(b) simply refer to the section of the US Tax Code that originally defined them. The largest difference between the two is the type of employer that offers them. 401(k)s are typically available to employees of for-profit businesses, while 403(b)s are typically available to workers of non-profit organizations and government entities. But they both follow a basic principle that can help you avoid a very rude awakening when you’re getting close to retire: put in a small amount of the money you earn on a regular basis and then one day, you will have much more than if you don’t.
The reason you will have much more is because of a wonderful process that drives all forms of investment: compounding interest. The money you set aside is invested in some way, whether it’s in stocks, bonds, cash equivalents or something else entirely. Depending on your individual risk tolerance, your money will compound at varying rates over time. Once you start accruing the interest from those investments, your total amount saved will grow and then you earn interest on your original money in addition to that accrued interest.
Think of it this way. Let’s say you can only invest $100 a month to start, and you choose a fund provided in your 401(k) plan that typically offers an annual return rate of 6% (which is modest, by the way). The money you put in over the year adds up to only $1200, but your account will be closer to $1233. That extra $33 is that interest you earned if it maintains the average 6% rate. $33 extra might seem like almost nothing to you at first, but if you repeat the same process a second year, you will now have about $2,543, about $143 of which is that accrued interest, more than the amount you put in every month. If you maintain that same consistent $100 monthly investment, here’s where you’d end up every 10 years:
- Year 10: $16,389 ($4,388 in accrued interest)
- Year 20: $46,207 ($22,206 in accrued interest)
- Year 30: $100,457 ($64,456 in accrued interest)
- Year 40: $199,160 ($151,159 in accrued interest)
I remember I felt floored when someone first showed me how that growth works. You really get a decent picture here of how minor gains at first transform into larger gains over time. The difference in the amount you gained between Year 1 and Year 10 seems tiny compared to the gains earned between Year 30 and Year 40, even though they were both exactly a decade and involved the exact same amount of money coming out of your paycheck.
Now let’s not beat around the bush: $200,000 is not enough for most people to retire comfortably on, especially when you consider that this is supposed to be 40 years into the future. But if you get stuck up on that, you’re missing the point. This whole scenario is based on the premise that you will be putting away $100 for every month you work over time, never a penny more or a penny less. I start this example with $100 because it’s a small number that most people can afford, especially when you’re just starting this process. Over time, as long as you are following through on the other key steps to financial independence, you will be able to put in more as time goes on. Try this same scenario but with one caveat: starting at Year 10, you’re now able to put in $500 a month instead. By Year 40, you won’t just have around $200,000; you will have $600,000!
You don’t have to imagine how much you would have if you’re able to get up to $1,000 at some point later on; you can plug in the numbers and see the math for yourself. There are many easy-to-use compound interest calculators out there, but this one is my favorite.
One Other Thing
I forgot to add one additional piece of very important information to these scenarios: employer matches. Many (but not all) employers will provide a matching contribution when you put money into their sponsored retirement plans. The matching rate is likely to vary and be capped depending on where you work, but a relatively common one is a 100% matching rate at the 5% contribution level. This means if you put in 5% of your paycheck into the plan, they will put an additional 5% at no cost to you. That right there is free money and that’s why I highly encourage you to meet your employer’s matching limit if it’s at all possible for you. Go back to our earlier scenario and envision your account putting in $200 from the beginning instead of just $100. Because that’s what this would mean. The numbers will speak for themselves.
Do It Yourself
As wonderful as employer-sponsored retirement plans are, not everyone has access to them. Whether you are currently in school or self-employed or only work a small number of hours per week, there are many reasons why you might not have the opportunity to invest in a 401(k) or 403(b) plan right now. The good news is that doesn’t have to stop you.
Individual Retirement Accounts (IRAs) are a great way to invest directly in your own retirement with your own money. You can set one up fairly easily from almost any brokerage (such as Fidelity, Charles Schwab, etc.) and begin investing in many of the same fund options you’d be able to invest in with a 401(k) or 403(b) plan. There are limits to how much you can invest into an IRA annually. Currently, the cap is $7,000 per year if you are under 50 and $8,000 per year if you are 50 or older. The limit for employer-sponsored plans is currently $23,000 per year. Many people strive to put away as much as they can for retirement by “maxing” one or both accounts. If you ever reach a point in your financial independence journey where that’s possible, I highly encourage it. But even if that’s far out of reach for you right now, just remember: every little bit helps.
I hope this information really puts things into perspective for you. One of the keys to financial independence is learning the best ways to set yourself and your loved ones up for success and I would consider learning how to consistently save for retirement to be near the top of that list. Although retirement investing is relatively simple to understand, there are certainly other factors I did not cover in this post, such as what type of funds to choose from or whether to select a traditional or Roth option, etc. I am not an investment advisor and ultimately do not feel it’s my place to dictate what is best for you when it comes to your individual investing decisions. In all likelihood, whichever organization your employer partners with to provide you with this retirement plan will have a website with a guide on deciding all of that. I highly encourage you to explore that in detail and learn as much as you can on your own. The more you know, the better prepared you will be to make the right decisions for you in your own life.
That’s all for now. Peace!
