Importance of investing early...

[EvrClrx311]

I had some free time today and was interested to run some simulations on the effects of different retirement strategies using real world market conditions. I think it is safe to assume that people nearing retirement right now are experiencing one of the worst stretches leading up to retirement that you can expect historically (the last 10 years has really been a lost decade)... so running models on investing over the last 30-40 years is a good place to start for worst case planning.

I'll edit this post as I do more of these and add to it (or I might just post below).

Set-Up... for the purposes of this study we'll follow an individual born in 1951. Lets assume he was in school until the age of 23 (1974) and graduated as an engineer. Today the average engineer out of school makes approximately $50,000 a year... which inflation adjusted back to 1974 would have been a starting salary of $10,470. Lets assume this engineer worked his way up over a 36 years career to be making $80,083 in 2010 (an average 5.5% yearly raise over his entire working career). Looks about right... someone starting out his career at 50K in today's dollars and ending it at 80K. Obviously in some fields you have more or less room for salary increase.

To keep things a little simpler (at least for now), we'll assume all retirement investments are into an Index Fund tracking the S&P500... so we'll use real world returns of the S&P500 with dividends included as shown on this site:
CAGR of the Stock Market: Annualized Returns of the S&P 500

Option A) 20% Always - If this individual decided to set aside 20% of his pay no matter what in every single year he worked. He would have set aside a total of $269,155 over 36 years that would grow to $1,681,611 in 2010

Option B) Increasing - If this individual decided to set aside 10% of his pay his first decade, 20% his second, 30% his 3rd... He would have set aside a total of $412,482 over 36 years that would grow to $1,441,663 in 2010

Option C) Late Start 30% - If this individual never saved for retirement until age 35 and then started socking away 30% of his pay... He would have set aside a total of $352,465 over 36 years that would grow to $934,095 in 2010

These are all scenarios that look at his retirement account at age 60... now lets see what his options are for an earlier retirement under these same three options:

By Age 50 he would have...
Option A) $1,307,900
Option B) $975,539
Option C) $601,426

Even with as bad as the economy and stock market is today... you can see that investing early is crucial in building a nest egg. The reason is that over 35 years you are all but guaranteed an average compounded return of 8% or more... if you wait till later in your career to really ratchet up the savings, you are hoping that a much smaller time period (10 or 15 years) while near the entire of your career will obtain good or above average returns.

If anyone has ideas for different scenarios or tweaks to this one let me know. I'm having fun with excel in my boredom

 

[MasterBlaster]

- No surprises in your post.

What I see alot in the financial "save more in your 401K" news articles is the case of someone who saves (inflation adjusted) X dollars a year from 20 to 30 years old and then stops saving. That gets compared to someone who saves his whole life starting at 30 (ie 30-65) the same amount (X inflation adjusted dollars). The chart then shows that the late starter never catches up with the early starter.

The moral of the story ! Don't be a late starter !

 

[EvrClrx311]

- No surprises in your post.

What I see alot in financial literature is the case of someone who saves (inflation adjusted) X dollars a year from 20 to 30 years old and then stops saving. That gets compared to someone who saves his whole life starting at 30 the same amount (X inflation adjusted dollars).

The idea that saving early is better is obvious... what I'm interested in is how small changes to the timing and amounts invested effect the end result. Another one I plan to look at is what happens if the person were born in 1941, or 1961 instead. Market conditions (when the ups and downs occur) play a huge role. Ideally you want more of the bad returns early on, if you're going to have them at all... In that sense, the young investors today really have a huge opportunity (hidden blessing) by starting off in such a dismal economy... that is if you can still afford to invest or have a job.

 

[MasterBlaster]

The idea that saving early is better is obvious... what I'm interested in is how small changes to the timing and amounts invested effect the end result. Another one I plan to look at is what happens if the person were born in 1941, or 1961 instead. Market conditions (when the ups and downs occur) play a huge role. Ideally you want more of the bad returns early on, if you're going to have them at all... In that sense, the young investors today really have a huge opportunity (hidden blessing) by starting off in such a dismal economy... that is if you can still afford to invest or have a job.

Agreed - the sequence and timing of market performance can make a huge difference. But what alternative does one have but to accept the time frame of your life ? Perhaps we are dealt a great hand... and perhaps not !

Per the young-uns lucking out, That is not certain at all and if you ask them they may not feel lucky at all. Markets could and (perhaps) should perform better than they have lately. But nothing is certain.

 

[FIREd]

In that sense, the young investors today really have a huge opportunity (hidden blessing) by starting off in such a dismal economy... that is if you can still afford to invest or have a job.

I think you are right. Historically, investing during secular bear markets like we have had since 2000 puts you in a position to take full advantage of the following bull market. If the next secular bull market is as powerful as the last two, the younguns like us who have only known market misery but still managed to invest should sit pretty. The question is, how far away is that next bull market?

 

[EvrClrx311]

The question is, how far away is that next bull market?

yep... its not about will the next bull market will come, but when. I'm guessing my ER will depend a lot more on that then picking age 44 or 52 out of the air right now and hoping an annual 7-9% annual return gets me there on the dot...

As you said... setting aside as much as you can during a bear market like this is really taking advantage of a once in a lifetime opportunity. I fear that many people in our age group are running from the market instead... later they'll wish they hadn't.

 

[FIREd]

yep... its not about will the next bull market will come, but when. I'm guessing my ER will depend a lot more on that then picking age 44 or 52 out of the air right now and hoping an annual 7-9% annual return gets me there on the dot...

As you said... setting aside as much as you can during a bear market like this is really taking advantage of a once in a lifetime opportunity. I fear that many people in our age group are running from the market instead... later they'll wish they hadn't.

The past 2 secular cycles had a period of roughly 35 years. If the historical trend holds, then the next bull market won't start until 2017-2018.

 

[EvrClrx311]

The past 2 secular cycles had a period of roughly 35 years. If the historical trend holds, then the next bull market won't start until 2017-2018.

I've noticed the same thing... think its any coincidence that these cycles are about a generation in length? Have you read the book "Predicting the Markets of Tomorrow" by O'Shaughnessy

Good read if you subscribe to the idea that the market can be understood better looking at long term trends and cycles.

Amazon.com: Predicting the Markets of Tomorrow: A Contrarian Investment Strategy for the Next Twenty Years (9781591841081): James P. O'Shaughnessy: Books

 

[NYEXPAT]

Hmm, I would be curious what a Japanese engineer born on the same date would think about all this?

 

[EvrClrx311]

Hmm, I would be curious what a Japanese engineer born on the same date would think about all this?

If he's investing in US equities and didn't become a nuclear engineer... I think its safe to assume that he's good to go.

 

[Jay_Gatsby]

There is an inherent flaw in the OP's original hypothetical. It assumes that those young enough to "start early" will pay attention at the right time (e.g., early-20s) to such financial advice. The "compound interest" message competes with the following:

1. Unemployment/underemployment
2. Peer pressure to have fun, fun, fun until daddy takes the T-Bird away.
3. Crushing student loan debt
4. Costs of being independent from one's parents
5. Pent up desire for an "upgrade" from ramen noodles, 10+ year old car, horrible roommates, etc...
6. Dating, fiance (wedding ring/costs), young family, etc...

This list could go on and on, but hopefully everyone gets the point. Saving young is a wonderful concept - in a vacuum - but the pressures of real life usually intervene except in the case of those with the strongest fiscal discipline. Most young people won't have the income or the right mindset until age 25, and some not even until they're age 30.

 

[EvrClrx311]

There is an inherent flaw in the OP's original hypothetical. It assumes that those young enough to "start early" will pay attention at the right time (e.g., early-20s) to such financial advice. The "compound interest" message competes with the following:

1. Unemployment/underemployment
2. Peer pressure to have fun, fun, fun until daddy takes the T-Bird away.
3. Crushing student loan debt
4. Costs of being independent from one's parents
5. Pent up desire for an "upgrade" from ramen noodles, 10+ year old car, horrible roommates, etc...
6. Dating, fiance (wedding ring/costs), young family, etc...

This list could go on and on, but hopefully everyone gets the point. Saving young is a wonderful concept - in a vacuum - but the pressures of real life usually intervene except in the case of those with the strongest fiscal discipline. Most young people won't have the income or the right mindset until age 25, and some not even until they're age 30.

I know I'm atypical, but I just turned 30 and I've been saving over 20% towards retirement for the last 7 years... I own a house, am in grad school part time, have two kids, and a wife that stays home with them by choice. I also have about 1.5 times my current salary in my 401k.

Most of what you listed is valid but boils down to excuses that people give for why they didn't start early enough... this thread isn't meant to say the average person is the engineer listed above. It's meant to show the average Engineer exiting college that starting earlier rather than later makes a bigger impact than he/she probably thinks or assumes.

People who fit your description above are likely to never stumble across this website... so it doesn't make much sense to try to appeal to them. They'll just look at you like you have two heads when you try to tell them what they should be doing with 20% of their salary... its much easier to mold your life and your spending around that money missing from the start... rather than trying to figure out how to give up 20% of your salary after already working 5-10 years.

I'm lucky to be in the situation I'm in now because someone took the time to explain this kind of stuff to me when I was 23 (without that guidance I probably would have just spent the money on more trips or a sports car). I've grown a lot in the last 7 years... and now I'm seeing why it made sense. I'm just trying to pass it on.

I'm starting to get the sense that many on this board have very little faith in the younger generations... tough times produce tough individuals.

 

[steelyman]

I'm starting to get the sense that many on this board have very little faith in the younger generations... tough times produce tough individuals.

I have a great deal of faith in the younger generations - just not the one I was in

My retirement investing started in the mid-90s, and at that time the limitations on contributions to employer-type plans (and Roth IRAs) were pretty low. It never occurred to me that I could invest outside of such a plan. I think this is an important thing to realize, even today with much higher investment limits.

 

[Milton]

Agreed - the sequence and timing of market performance can make a huge difference. But what alternative does one have but to accept the time frame of your life ? Perhaps we are dealt a great hand... and perhaps not !

Yes, exactly. Hindsight is 20/20, but unless one has a time machine it is of limited utility to sift through past results and contemplate what might have been.

 

[Milton]

I'm starting to get the sense that many on this board have very little faith in the younger generations...

Never trust anyone under 40!

 

[ziggy29]

Moving forward it doesn't feel like that "5.5% annual raise" assumption is going to hold... it would have to be a lot more than that given how many of us have had virtually no raises for several years already.

 

[Jay_Gatsby]

Moving forward it doesn't feel like that "5.5% annual raise" assumption is going to hold... it would have to be a lot more than that given how many of us have had virtually no raises for several years already.

Agreed. I haven't seen a 5.5% raise in many years. Mostly in the 2-4% range, except when I switched jobs and grabbed 20%. Perhaps that makes up for the lower raises at my then-current employer.

They say your biggest "raise" is when you change jobs....

 

[EvrClrx311]

Agreed. I haven't seen a 5.5% raise in many years. Mostly in the 2-4% range, except when I switched jobs and grabbed 20%. Perhaps that makes up for the lower raises at my then-current employer.

They say your biggest "raise" is when you change jobs....

That number really doesn't mean much for the purposes of this example... In fact, the lower the annual raise number the better the final ratio actually turns out (retirement account as a multiple of end salary)

As I stated... some professions have very little growth in salary... while others go up a lot more over a career. What is important is what you end up with in your retirement compared to what you expect to live on (which is almost always directly related to your salary).

Also don't forget that inflation will push raises up higher some years than others, and I think we all agree that some form of higher inflation is coming within the next decade.

 

[EvrClrx311]

Here is an example to hit home the point:

Lets assume both Mike and Jim start different engineering jobs at the age of 23. Both start out with a salary of $50,000 but due to the job market and career path differences Mike averages a 4% raise while Jim averages 5.5% over their entire careers. Both work until age 65 and put away 20% of their pay religiously into retirement accounts that average an 8% return over their entire time working.

Obviously Jim, with a higher salary will end up with a higher 401k balance, but he also has a much higher salary when he's 65 and has lived life accordingly (location, mortgage, luxuries, etc...)

Jim's final salary at age 65 is $136,902 in today's dollars while Mike's is a more modest $75,025. Using the same rate of return over their lives...Jim's 401k balance is $2,013,542 and affords him $80,541 to live on a year using the 4% rule. Mike however, has a 401k balance of $1,592,688 which affords him a 4% withdrawal rate of $63,707 a year using the 4% rule. All numbers are in today's dollars (inflation removed).

Obviously, Jim has more to live on in retirement... however he has to bring his living expenses down more than Mike to make it in retirement. His 401k produces a yearly income that is 59% what he was making as a salary at 65... Mike's on the other hand is producing 85% of what he was making at retirement.

As with so many thing in life... its relative. Sometimes the ratios are a lot more important than the final numbers. This is why some people can complain that 80K a year in retirement isn't enough... while others can easily get by on half that much.

This post isn't meant to compare which life is better... I think many would choose Jim's path all else considered just because more is better. This is only meant to show that someone making a 5.5% raise actually ends up with a higher 401k... but one that represents a smaller amount relative to their end salary. In the end... it isn't so much what your number is... its about does that number work for you and your lifestyle. In that sense, getting a lower raise (and along with that learning to live on a lower income) can give you a better shot of reaching that ER goal earlier.

Point being... someone expecting to triple their salary by retirement and live on that amount in retirement is going to have a much more difficult time getting there than someone who made the same salary their entire lives, put away the same amount, and planned to live on it in retirement too.

 

[ChadR]

I think these illustrations are extremely valuable to younger people on helping overcome the competing items on Grinch's list.

However, I really dislike the 8% average annual returns. Average annual returns are way misleading compared to how market returns really work. I started investing in 1999 and my true IRR is way way below 8%. Given the weighting factor that occurs to investing incrementally over time younger people who have a "lost decade" can be penalized too. It's not just people closer to retirement that hate a lost decade. That is the whole point of compounding.

Fail to get good compounding the first 10-20 years and all your early savings won't impact ending portfolio balances nearly as dramatically as when you assume these high and constant average annual rates of return.

 

[DJRR]

If anyone has ideas for different scenarios or tweaks to this one let me know. I'm having fun with excel in my boredom

One scenario that I am interested in is what about a HS senior who takes a job that makes 25% less than the engineer out of high school, maxes out their IRA at $5k per year starting at age nineteen, and skips college and the 100k cost while earning a salary for 4 years. Lack of college drinking aside, Who turns out better for early retirement?

 

[MasterBlaster]

One scenario that I am interested in is what about a HS senior who takes a job that makes 25% less than the engineer out of high school, maxes out their IRA at $5k per year starting at age nineteen, and skips college and the 100k cost while earning a salary for 4 years. Lack of college drinking aside, Who turns out better for early retirement?

Ah the steady yet lowly paid ant versus the highflying grasshopper.

I suppose that the time-weighted savings amounts of each will tell the whole story.

So yes, the lowly paid ant can indeed outperform their higly paid grasshopper peers.

 

[Jay_Gatsby]

One scenario that I am interested in is what about a HS senior who takes a job that makes 25% less than the engineer out of high school, maxes out their IRA at $5k per year starting at age nineteen, and skips college and the 100k cost while earning a salary for 4 years. Lack of college drinking aside, Who turns out better for early retirement?

It's not a binary question. The high school senior could still go to community college part-time while working full-time. Or s/he could get a scholarship, or some other sort of financial aid. Lots of possibilities for bringing that $100k cost down and still work.

The key point remains. Start early no matter how little you can contribute. Unfortunately, and as I mentioned in response to the OP, this all assumes that the high school senior has financial wisdom beyond his/her years. This is why we should make it mandatory that all high school seniors go through at least one practical finance course. Courses in entrepreneurship to find the next Gates, Ellison, Jobs, Zuckerberg, etc.... are nice, but who is going to invest in a company if the founder can't handle his/her own finances?

 

[EvrClrx311]

One scenario that I am interested in is what about a HS senior who takes a job that makes 25% less than the engineer out of high school, maxes out their IRA at $5k per year starting at age nineteen, and skips college and the 100k cost while earning a salary for 4 years. Lack of college drinking aside, Who turns out better for early retirement?

here you go...

You provided:
Starting Salary: 25% less than engineer
Started Working: Age 19 (1970)

Assumptions (variables you left out):
- Salary increase: 5.5% (same as engineer)
- $5K set aside in 1970 is not realistic since it is over half of his take home pay. I'll assume what you meant is 13.3% over his working career (which would be the equivalent of starting out today saving $5K on a $37,500 starting salary - which is 25% that of the starting for the engineer)

Results:

He would have $945,062 today... which would represent 16x his salary of $58,209. He could have had the option for early retirement in 2006 (at the age of 55) when he had 21x his salary... but would have required moving some or more of his retirement to safe investments (something I don't account for in these examples because though it makes the scenarios more realistic, it makes them harder to understand at a base level, and harder to define as people have different assumptions and opinions about how and when to move towards bonds and away from equities... like the S&P500 used for this example)

As I indicated in my last post... retirement is more about what you have compared to your salary... not how big the actual number it. In that sense, if someone started working right out of HS with an extra 4 years to grow... AND was also on a career track with a lower increase in salary. They'd likely end up with the possibility of achieving early retirement much easier than the engineer in our first example... because they'd need a lot less money to retire.

Its no surprise, but maximizing how much you save and how early you start... will get you to ER faster. One of the other points I was trying to make is that the more your salary increases over your working career... the harder it becomes to ER if (big if) you plan to carry that higher income into retirement spending too.

 

[EvrClrx311]

I think what the example was really asking is... can bypassing college and starting to work earlier make your life easier in terms of getting to ER?

Here is a better example IMO...

first lets bump the birthday back to 1946 so they would both be 65 in 2011...

Lets use the same two guys: Engineer who went to school and started working at age 23 making $50K today's dollars in 1969... vs... HS grad who skipped college to start working for 25% less than engineer in 1965. Lets assume that the engineer salary increases an average 5.5% but the non-college grade has a 5% increase due to less of a career ladder. Lets also assume both start saving 15% of their salary right away and continue for their entire careers investing it all into the S&P500 which we'll use its yearly returns to calculate the actual 401k balance they would have.

Engineer: Starting Salary in 1969 is $8,198 ($50K today's dollars), and ends up with a salary of $77,680 in 2011. His 401k grew to $1,312,127 or 17x his final salary

HS-Grad: Starting Salary in 1969 is $5,480 ($37.5K today's dollars), and ends up with a salary of $51,700 in 2011. His 401k grew to $1,191,519 or 23x his final salary.

I would argue that the HS-Grad ended up better off... he certainly had a better opportunity to ER in 1999:

Engineer: salary was $40,858 and 401k was $1,129,730 (27x salary)
HS-Grad: salary was $28,788 and 401k was $1,050,005 (36x salary)

The answer is definitely YES... but you have to actually save. I think that is the problem. When you first start working is the optimal time to learn to LBYM and start saving for retirement... however, a person who starts working at 19 is even less likely to make that decision to save than someone who is 23.