Congratulations on starting to think about retirement at age 21! My wife and I gave a personalized version of this letter to our niece when she graduated from college. J. L. Collins was a major inspiration both for writing this letter and its content.
You are now focused on the next step in your career and this is how it should be. We would also encourage you to start thinking about your retirement now. Yes, retirement may be decades in the future, but it will be here sooner than you think.
Our philosophy since before we got married has always been to “LBYM” - Live Below Your Means. Spend less than we earn and invest the difference. You have a choice with every dollar you earn: You can spend it or invest it. If you invest it, it will work for you the rest of your life through the power of compounding.
Avoid most forms of debt. Borrowing money limits your future choices because you have to repay the loan. Never borrow money to buy something if the loan repayment will last longer than the asset you are buying.
Most people do not understand the importance of LBYM, and this is one reason why many people live paycheck to paycheck - even some people with relatively high incomes. Some spendthrift people will mock anyone with LBYM habits. Always remember that she who laughs last will laugh best. As you earn pay raises in the future, resist the urge to inflate your lifestyle to match the increase in income. Use the majority of each pay raise to increase your savings rate.
You may have taken a finance class that taught you about compounding. Compounding is one of the most powerful forces in nature. Make it work for you. To get the most benefit from this force you need to get started as soon as possible. Better yet, start right now, while you are young and time is still on your side. Time squandered now can NEVER be recovered.
Retirement comes for most of us, but not always on our own terms. We may be forced out of work due to health issues, or we may be laid off and unable to find a good job. Age discrimination against people over 40 is illegal in this country, but it is also alive and well in the world of business. Our goal should not be to save enough money to retire when we are 65 or 70 years old. Our goal should be to save enough so that we can retire by age 45 or 50 if we get laid off and cannot find work.
Money can buy lots of things. But the most important thing money can buy is your freedom. Freedom to live the way you want and where you want. You can find many websites and blogs about the FIRE (“Financial Independence, Retire Early”) concept. We encourage you to read some of them. One important takeaway is this: Financial independence is required. Retirement is optional. Financial independence means that your investments produce enough income to cover all of your regular and irregular expenses, with some margin of safety. Once you reach financial independence you are free to keep working if you like, or do something else if you like. Only when you no longer need a paycheck will you have full control over your life.
“Keeping up with the Joneses” is foolhardy. There will always be people with more money than you. Buying stuff you don’t need and rarely use is not worth the freedom that money can buy you. Don’t ever spend money on something if the primary purpose is to impress someone else.
There are many ways to invest. Over long time spans, the stock market has always provided better returns than most other common investments. There are three basic ways to invest in the stock market: buy individual stocks, buy managed mutual funds, or buy index mutual funds or exchange traded funds. Most people are not good at picking individual stocks. Most professional money managers can’t beat the stock market index that applies to their fund category. So don’t waste your money on managed funds. Invest in low-cost index funds to minimize fund expenses and have the best chances for better-than-average gains. Investing in index funds is very easy and will take up little time or energy from year to year.
One point not emphasized strongly enough is that a 401(k) with company match is a starting point and is not nearly enough to fund a retirement. Take any employer match first – that’s free money and anyone is a fool to not accept the maximum offered. After that further investment goes into a Roth IRA or 401(k) up to the legal limit. After that the savings/investment goes into a taxable account. This is called “Paying yourself first”.
The general wisdom is to save 10% of your gross pay in order to have enough to retire when you are 65. This is not adequate. You should plan to save at least 25% of your pay, and more if possible. The more you save and the sooner you start, the more time there is for compounding to work for you … time that can never be regained if you don’t start early. You may think you can’t afford to do what we are recommending. In reality, you can’t afford NOT to. Investing to buy your freedom will be worth far more to you in the long run than almost anything you can buy today. Long term gain is usually worth far more than immediate gratification.
You win twice if you can sustain a high savings rate: The more you save, the sooner you will reach your financial goals. And the less you spend to maintain your lifestyle, the less you need to save to fund your retirement.
The hardest part of saving and investing is ignoring instincts and emotions. You have to learn to ignore the sinking feeling and near-panic when the stock market drops half its value. Sure as tomorrow’s sunrise, someday it will, and with it half the value of your retirement fund. That’s when investing and staying the course is the hardest. Over long time spans, the stock market has always gone up.
Pensions and other retiree benefits are great to have, but not every employer offers them. Unfortunately, many employers (in both the private and public sectors) that did offer them have reneged on their promises. Be grateful if your future employers offer these types of benefits, but don’t count on them for your entire retirement. Have a plan for if/when an expected pension goes away. Don’t rely too heavily on promises that may be broken in the future, no matter how strong you may think your employer is.
Take your time going through the books we recommend. There is no urgent rush and you do have a life to live. The only quiz will be the one in 30 years or so. You can retire if you pass. You must keep working if you fail. What you do with your money now, and over the next decades, will have a multiplying effect on your standard of living in the last half of your life.
The choices you make now will have a huge effect on the lifestyle you can afford when you eventually stop working. Your future self will either say “Congratulations to me!” or “What an idiot I was!” You know which words you would prefer to hear.
Suggested Reading: (may be available for free in your local library system)
The Millionaire Next Door: The surprising secrets of America's wealthy. The numbers are dated but the philosophy will always be valid.
Thomas J. Stanley and William Danko
The Simple Path to Wealth
J. L. Collins
Your Money or Your Life
Vicki Robin and Joe Dominguez
Excellent blog on all retirement issues and also most life issues:
www.early-retirement.org
