Retirement planning should take place early but most people simply don’t think about this phase of life until they are fast approaching it. In looking at the accumulation of one’s retirement assets, an investor must focus not only on how much and when they save but also on the return from the portfolio. While we have less control over the latter than the first, which of these two components matters the most?
A recent paper by Craig L. Israelsen, an associate professor at Brigham Young University, addressed this very question and found the answer is based upon age. His analysis started with a 25-year-old worker earning $35,000 per year, increasing 3 percent per year. The worker in the example saved 6 percent annually and grew his portfolio at 6 percent, as well.
The goal was to determine what this worker would accumulate assuming a retirement age of 65. For this investor, the account value at age 65 is $528,007. However, if the portfolio grows 10 percent annually and the savings rate stays at 6 percent, the portfolio increases to almost $1.4 million by age 65. On the other hand, if the savings rate increases to 10 percent a year and the portfolio returns remain at 6 percent, the ending portfolio value at 65 is only $880,012.
This same trend – the portfolio rate of return having more impact on the ultimate account value than the annual savings rate – holds true for a 35 year old, as well.
However at age 45 and beyond, an investor benefits more from increasing the savings rate than from attempting to increase portfolio returns. The results clearly indicate that saving is much more important than generating higher returns. This logic seems counterintuitive: One would think a person that is late to the retirement game needs to make up for lost time by trying to build a portfolio that can generate higher returns. However, this research suggests the older investor needs to save more each year rather than build an overly aggressive, high-risk/high-return portfolio.
The bottom line is this: If you have more than 20 years until retirement, then compounding can really work in your favor. Those within 20 years of retirement, however, should be more aggressive with the rate of their contributions than the rate of their returns.
What the analysis suggests is that the performance of a portfolio should never be expected to make up for under-saving. If you are young, the message is clear: A contribution rate of 1 percent to 2 percent of income into a 401(k) or IRA is simply inadequate.
While this advice is hardly new, we are all guilty of allowing our wants to squeeze out our needs. And in this case, an inadequate savings rate now will inflict a heavy price later.
The most important step that can be taken to help us be better prepared financially for retirement is to increase the annual savings rate to at least 6 percent of income and start early.
If you wait, your contributions will have to do more of the lifting than will your returns.
Life is a journey; plan for it.