When retirement is decades away, it’s easy to postpone saving for it in favor of the more immediate demands on your income. Stretching your monthly budget to cover housing, food, clothing, student loan payments and other obligations can push retirement savings to the back burner.
But putting off retirement savings for even a few years can be a costly mistake. Time can be one of the most powerful tools in a retirement savings plan, allowing you to build a healthy nest egg even if you are only able to save small amounts. Therefore, work to start saving for retirement early in your career, whether through an employer’s 401(k) plan or an individual retirement account (IRA).
The magic of time
The power of time on your retirement savings is due to the magic of compounding. Let’s look at two hypothetical examples to show how this works:
Bob, 22, just landed a job as an accountant making $50,000 a year. Let’s say he decides to contribute $500 per month to his employer-sponsored 401(k) plan.
If Bob continues to save the same amount until he retires at age 65, earning a hypothetical 5% annual rate of return on his investments, after 43 years, the value of his account at retirement at age 65 will be nearly $858,000.
Bob’s colleague, Sally, gets a later start and doesn’t begin contributing to her account until age 45. Even though she contributes $1,000 a month and earns the same hypothetical rate of return, she will have just $397,000 in her retirement account at age 65 — less than half of what Bob has saved.
While many investors go in search of the magic double-digit stock gain, long-term investors shouldn’t overlook the power of consistent contributions to their retirement accounts — even if their initial contributions are very small.
Small amounts can make a big difference
The power of compounding works on smaller investments, too. Using the example of Bob and Sally, let’s look at how this can work.
Let’s say that Bob can only afford to save 3% of his salary, or $125 each month, for retirement. Over 43 years, Bob will amass a nest egg of $215,000 at retirement, a little more than half what Sally manages to save by putting away $1,000 a month. Overall, Bob will have contributed just $64,500 compared to Sally’s $240,000.
While that may not be enough to fund Bob’s entire retirement, it’s a start. And he would be better off than many of his peers. According to a recent report from the National Institute on Retirement Security, two-thirds of working Millennials have nothing saved for retirement.
Now, of course, investment returns aren’t usually steady like these hypothetical examples and typically fluctuate. In addition, salaries typically grow over time, so a percentage contribution would typically grow over time. But with enough time on one’s side, even small contributions can make a big difference to an overall retirement portfolio.
Education that pays in the long run
Understanding the power of compounding and its effect on a portfolio over time can be a powerful incentive to begin saving earlier. Because contributions to traditional 401(k) plans and IRAs are typically made with pre-tax dollars, you may also have additional tax advantages. With many choices to make and options to consider, a Financial Advisor can help you create a strategy that will put you on the right track to saving for the future and achieving your long-term goals.
Lisa Shelton and Brooke Lowery are financial advisers in Vancouver at Morgan Stanley Smith Barney LLC (“Morgan Stanley”). They can be reached via email at email@example.com or at 360-992-8062.
This article has been prepared for informational purposes only. The information and data in the article has been obtained from sources outside of Morgan Stanley. Morgan Stanley makes no representations or guarantees as to the accuracy or completeness of the information or data from sources outside of Morgan Stanley. It does not provide individually tailored investment advice and has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this article may not be suitable for all investors. Morgan Stanley Smith Barney LLC (“Morgan Stanley”), its affiliates and Morgan Stanley Financial Advisors or Private Wealth Advisors do not provide tax or legal advice. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for legal matters.