The Miracle of Compound Growth and Building a Nest Egg
Setting Your Retirement Goal
Experts recommend your retirement income goal should be about 80% of your final pre-retirement annual income.?In other words, if you make $100,000 a year when your reach retirement, you will need $80,000 per year to live the lifestyle you have become accustomed to. Social security was designed to cover roughly 40% of the retirement annual income requirement, but that will depend upon how much you have paid in over the last 35 years of your working life. Online social security benefits estimators are helpful to give you an approximation of how much you might expect when you reach full retirement age. The MaxiFi Planner is a good online calculator to help you plan your own retirement financial scenario: https://maxifiplanner.com/esplanner-basic-now-maxifi
The most common rule takes an easy formula that simply divides your target annual retirement income by 4%. To reach that $80,000, for example, your goal is about $2 million ($80,000 / 0.04). While investment returns vary considerably over time, the underlying assumption here is that you will make a 5% average annual return on your investments. The $2 million doesn’t include the social security benefits that you will receive, and it also assumes you live for about another 30 years in retirement. A longer life, expensive medical care, and other unknowns can enter in and change all this, but for planning purposes, this approach is reasonable.
Tracking Your Retirement Progress
The recommended savings each year is at least 20%, but preferably 25% would give you a larger cushion, a margin of safety. Another way to see if you’re getting where you need to go, is to look at where you are based upon your age:
All of these are a rule of thumb, generalized formulas that will get you close enough to having what you hope to have when you retire, and living the way you were living right up to your retirement. Besides the social security that will help support your annual expenses, take full advantage of the company 401(k) match by electing to deduct enough for your 401(k) that you get the maximum match that your company offers.
Rule of 72
The amazing math of compounding can be demonstrated in some examples, and a handy formula that tells you how long it takes to double your savings at various assumptions of investment returns. If you start with a penny, double that the next day, double the higher amount the following day, and continue this pattern for thirty days you would end up with well over $5 million!
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The Rule of 72 shows us how long it will take for an investment to double, given a fixed annual rate of return. In our example of 5% / year investment return it will take 72 / 5 = 14.4 years to double the amount. Taking an extreme case of only 1%, today more than most savings accounts pay in interest, it would take 72 years to double your initial savings.
No matter how tempted you may be to withdraw some of your retirement savings, or borrow against your 401(k), resist that temptation with all your might. People borrow against their 401(k), and then pay the account back the amount borrowed, including interest. They argue that they’re simply paying back to themselves, but the interruption of that compounding effect diminishes your overall total amount at the time you finally retire.
Let’s take one more look at what a $1,000 initial investment will expand to with different investment return assumptions across different periods of time:
Summary
Most Americans won’t begin to provide for retirement at the same time they begin their working life. There are many reasons for this. Student loans can be a huge debt requiring service, initial jobs may be low paying, it is a challenge to save at a young age, especially 20-25% of income. The long-time horizon until retirement tends to lull us into a false sense of security that allows us to think we have plenty of time to get all that figured out later on in life.
But the sooner you get started saving, the less you will need to have deducted throughout the rest of your life. The miracle of compounding takes over, and your nest egg begins to grow and flourish into providing you with a comfortable retirement lifestyle rather than having to take into your autumn years financial fear along with everything else that comes with growing older.
The $2 million hypothetical retirement target won’t all come from you and your earnings. It will come from investment returns, compounding, it will come from company 401(k) match amounts over your working lifetime, and you will have other sources to fall back on, from social security to sales of assets you accumulated throughout your life. Though $2 million seems like a daunting number, following a plan outlined here can lead to a pleasant surprise in terms of just how easy it is to attain your dream if you plan - and get started – NOW!