Long, long ago, in a galaxy far, far away — back when I turned 30, that is — I didn’t understand the concept of retirement planning. 65 was a number I couldn’t relate to. If I thought about retirement at all, I fantasized that I’d win some kind of nebulous career jackpot and never actually have to worry about it. If that didn’t happen, I’d just sleepwalk through my financial life until I had no choice, at which point I’d magically work it all out.
Well, that was then, this is now, and as the stock market pulls us deeper into the muck of the worst financial crisis in 80 years, I’ve decided it’s my duty to start waving my arms, jumping up and down and shouting in the faces of today’s 30 year olds (you know who you are): “Max out those 401ks – NOW!!” Forget about Social Security. Its long-term survival is no longer an even bet, and if it somehow does make it, don’t expect it to provide more than token support by the time 2043 rolls around.
So even with the Dow dropping like a rock (and maybe especially), if you’re a 25 or 30 or 35 year old there is simply no counter argument: you have to start maxing out your 401k today. If it makes you crazy to watch large cap stocks turn tiny, put your money in the lowest-risk cash vehicles your plan offers — money market funds, low-risk bonds, whatever makes you comfortable — until a bit of sanity returns to the market. But please do put your money somewhere. Max’ing out your 401k has to be Task Number One on the to-do list, if you haven’t already done it.
To make the point even more emphatically, allow me to don my blogger’s top hat and tails and perform a simple magic trick, for your fiscal pleasure.
Imagine you’re 30 and earning $50,000 a year. Times are tough, so let’s assume that over the next 35 years your average annual income will rise by only 3% a year, while your investments will grow by only 5% a year. With the latest round of Wall Street carnage still smoldering in the background those numbers may not seem so bad, but historically they’re way down there, especially given your 35-year time horizon. By 2043 the market will have gone bull and bear so many times that the darkness of 2008 (and 2009?) will be a distant memory. But let’s be modest in our estimates anyway.
Being both a new hire and a savvy 30 year old, let’s say you decide to immediately start pumping 10% of your annual pre-tax income into your 401k. Because your company is one of those well-managed firms that still ponies up what’s called a matching contribution — in this case a robust 6% — as long as you contribute at least 6% of your salary, the company will match it. That extra 6% is actually “found” money, because just by signing up to save, you’ve effectively increased your salary by 6% per annum. And since all of it’s pre-tax (yes, you’ll have to pay tax in 35 years — but that is then, this is now), 10% adds up to a lot more in actual dollars than it would if you were putting away 10% of your take-home. Plus, it’s carved right off the top of your paycheck, which cuts down the amount of tax you have to pay every two weeks.
Now move the calendar ahead 18 years. It’s a few months before your 48th birthday and you’re having a mid-life crisis. You’ve been getting increasingly ornery about that 401k contribution – “certifiable” might be a better word – and you now decide you’ve had it with deferred income. You’re going to stop contributing and never start again. To calm your traumatized wife, you grudgingly agree to leave your money in the 401k until you’re 65, allowing it to continue its unexciting but reliable 5% annual growth.
Over the years you’ve become friends with a colleague who works in the same department at the same salary at the same company as you. Oddly enough, he even has the same birthday. When it comes to 401k’s, though, he’s your exact inverse: where you started out savvy, he started out ornery, refusing to invest anything in his 401k despite the company’s (and your own) pleas. To shut you up when you pressed him, he once memorably intoned “Live for today, tomorrow will take care of itself!” — dangerously mangling a dated 1960’s tune, while at the same time making no sense.
By now, though, he’s married, has two kids, owns a house, and is becoming increasingly nervous about where all this “Live for Today” stuff has left him.
A few months before his 48th birthday – coincidentally the same night you’ve turned ornery – he awakens at 3am in a cold sweat. The Ghost of Contributions Past has just been shouting at him in a dream that Tomorrow never had any intention of Taking Care of Itself – in fact Tomorrow is now cannonballing straight at him like a runaway train. Half-asleep and in a panic, he races to his laptop and arranges to start contributing 10% per annum — just like you. Contritely, he realizes that you should have been his role model all along — unaware that when he sees you tomorrow you’ll completely confound him by announcing that you’ve decided he was right after all: tomorrow will take care of itself (it won’t, but this is a parable, so bear with me).
Now, at age 48 your friend’s salary, like yours, is a little north of $85,000. During lunch the following day, while you try to ignore him he insists on explaining his revelation. “I was truly freaked until I realized that I’ve got 18 years left to save — and frankly, now that I know you’re stopping, my total contribution will be a lot bigger than yours because I’m starting with a much higher salary than you did. My 10% plus the company’s 6% will add up to a lot more real dollars. So to make you reconsider this “Live for Today” idiocy, I’ll offer you a bet: I’ll wager that on retirement day I’ll have more money than you do.”
To your annoyance, his reasoning seems sound: you did start at a much lower salary and contribute much less than he eventually will — and now that you’ve shut down your contributions you’ll never be able to catch up. In fact, you calculate that his contribution will end up more than 65% higher than yours. Sadly, it’s pretty clear: in the end he’ll do much better than you. Unless you change your mind.
Being stubborn and deeply committed to your midlife crisis you decide you won’t change your mind. But here’s where the magic comes in. When you get back to your desk you run the numbers – and decide to take the bet.
According to your calculations, on the day you both retire you’ll walk onto the golf course with $678,000. And despite his 18-year race against time (and you), your friend will walk off in the other direction with just $466,000 — 31% less than you! To even reach that number he’ll have had to contribute $76,000 more of his hard-earned money than you did, and the company will have had to award him $46,000 more than they awarded you. Yet precisely the same investments will have earned you $561,000, while earning your friend less than half that.
But that doesn’t make sense. You started at 30 and stopped at 47; he’s starting at 47 with a lot more cash, and will stop at 65; yet you’ll wind up over $200,000 richer. How will this wonderful trick be performed? Through a lovely bit of financial legerdemain called “compounding”. The 5% earned by your investments may have seemed anemic at the time, but with 18 more years to work its will on your behalf you’ll come out way ahead. Despite your bizarre decision to stop contributing at the age of 48, and despite your friend’s considerably larger overall contribution, 5% of a smaller initial pie spread out over 36 years will earn you more than twice as much as 5% of a larger initial pie spread out over 18 years (that’s earnings, not total cash).
Now this is the moment at which you’re supposed to leap to your feet and shout “Where’s my 401k site?” But if you’re still not convinced, let’s run another quick hypothetical. Let’s say you didn’t turn ornery at 48, but instead kept contributing 10% per year till you turned 65. We know your late-blooming friend will wind up with $466,000. Guess how much you’ll wind up with?
$1,157,000. All because you started contributing 10% a year at age 30.
At this point in our story, if you happen to be age 30 and there’s still no 401k fire in your belly I’d like to ask you a favor: please post a message on this blog and tell me why. At age 30 (or 25 or 35) the path to retirement is spread out before you like the yellow brick road. It’s never too early to start – but sometimes it’s too late. Wall Street will rise again, but that doesn’t even matter right now. The original Roman phrase was “Carpe Diem!” and it doesn’t mean “Live for Today” but “Seize the Day!” So what are you waiting for? Seize it!
Or to coin a new Roman phrase: “Seize the 401k! Then Max It Out!”
Burt Shulman and Ken Ennis are contributors to the Fund.com Expert’s Desk and Managing Partners of ESE Advisory Group LLC. For more on Burt, Ken and ESE Advisory Group LLC