Earlier this week, I wrote about the boomers' seriously underfunded retirement savings accounts. My friend Sydney commented (on my Facebook link) that "people living beyond their means and not understanding saving is a huge problem. Not only for the older generation, for which it's too little too late, but the younger generation...who prefer to spend on entertainment, designer labels, and the Starbucks factor rather than saving for homes or putting money away to compound for their retirement."
Sydney is right on, and she and her husband are a very sensible young couple who are making wise decisions for their family and their future. However, she uses one word that worries me: "compound."
What troubles me is that the word "compounding" is often coupled with the word "magic." Google the two words together (or try "compounding" + "miracle"), and you will see what I mean. The idea is that if you reinvest the interest on your initial investment, over time it will grow to dizzying amounts. You can prove this using a simple calculator.
Lots of people believe that this works in the real world as well. They think that if they put a few thousand dollars away every year, especially if they start when they are young, they will eventually have enough for a comfortable retirement. And indeed they might, if they happen to buy in at the beginning of an extended bull market, or if the market consistently expands faster than the rate of inflation, with no serious setbacks.
But they might discover that, despite decades of disciplined saving, they do not have nearly enough. The magic of compounding goes *poof* if inflation roughly equals the growth of their investments, or if a market "correction" or recession cuts their investments' value in half (even for just a year or two), or if their particular funds do poorly; or if they panic when the market tanks and either stop investing or--worse--withdraw their funds; or, sometimes, if they neglect to panic and stubbornly hold on while the market goes completely south...
In real life, some people experience the magic of compounding, while others lose their shirts. I suspect that most of us pretty much get out whatever we've put in, plus inflation. If we invest fairly conservatively, keeping an age-appropriate ratio of stocks to bonds for safety, our investments will somewhat outpace the rate of inflation in good years, enabling us to survive the bad years when the market tanks but inflation continues. At least that's what seems to be happening to the Neffs.
Example: In the late 90s my employer and I contributed a total of $32,766 to a 403(b). I left that job exactly ten years ago and added nothing more to the account, which was nicely balanced among a bond index fund, a stock index fund, a balanced fund, and a growth fund. Over the decade, it went up and it went down and it went back up. Its value today is $38,212. Does that sound good?
Well, let's look at the inflation rate for 2000 to 2009. What you could buy for $100 ten years ago would cost you $129.85 today. This means that what I could have bought with $32,766 ten years ago would cost me $42,547 today--and my magically compounding account holds $4,335 less than that. In buying power, I have been losing money, despite the market recovery of 2009.
My response? Invest more. We've been saving heavily over the last twenty years, because we know we're soon going to need every penny we can squirrel away. We don't expect any magic of compounding. We don't even expect our savings to keep pace with inflation, though we will be pathetically grateful if they do. We just know that if we don't save it, we won't have it.
How much do you need to save for retirement? Short answer: if you work and save for 45 years and are retired for 15 years, you probably need to put away from 1/6 to 1/3 of your income every month. If you work and save for 40 years and are retired for 20 years, you'll need to save from 1/4 to 1/2. (The lower figure assumes that half of your retirement income will come from Social Security; this may be optimistic.) In other words, what you save is what you will get, more or less.
Young people and even some middle-aged people tend to sigh and say, "I guess I'll never retire." Fine, if your health permits and there are jobs available for octogenarians. Not so fine if your company folds or you get Alzheimers or heart disease or cancer.
When Americans traded guaranteed pensions for 401(k)s, we took an enormous gamble--and most of us lost. When independent-minded folks argue that we should not help people who lack the foresight to help themselves, they may not realize the enormous amount of foresight required to self-fund retirement. (A lot of these independent-minded folks are unaware that they themselves have saved far less than they will need.) People who assume that they are going to go on living in the style to which they have become accustomed are in for a big shock.
The facts are becoming increasingly plain. There is no guaranteed magic of compounding, except on spreadsheets. Few people are saving enough to retire without drastically changing their lifestyle. The government is as overspent as the rest of us and is unlikely to be able to solve the problem. The best retirement plan? Save like hell, and figure out how to arrange your furniture attractively in a one-bedroom apartment. Oh, and you might want to be really nice to your kids.