Saturday, January 13, 2007

How much should you save every year? Let's be realistic.

FMF has a comment on his Free Money Finance blog about the book "The Net Worth Workout:...". That book points out that someone who had invested $1000 annually for 44 years would have retired with $600,000.

I find this ridiculous -- not the numbers which may be mathematically accurate. What I object to is the scenario. There's been a good deal of inflation in 44 years. Forty-four years ago, in 1962, the average wage was $4291, and that's yearly, not monthly. $1000 is more than 23% of a pretax income of $4291. In 1962 $1000 was bit much to expect of someone in their 20's starting a family and probably earning less than this average wage. On the other hand, in 2005 the average wage was $36,952 and $1000 would be less than 3%, hardly an adequate savings rate for someone about to retire.

A more realistic scenario would be someone who invests a fixed percentage of his income, adjusting the contribution to his nest egg as his salary increases. I have a spreadsheet available online that shows that someone who earned the Social Security average wage and invested 10% of his income in stocks beginning in 1962 would have have $754,269 at the end of 2005.

While a more realistic scenario than the one in the book, there are still flaws. One flaw is that earning the Social Security average wage throughout your working career is improbable. More likely it will be lower than the average when you're young and then increase as your career develops.

A major flaw in the spreadsheet is that it does not compute the effect of taxes. The actual value of the nest egg would be less, because a significant part of the S&P 500 return is dividends, which are taxed when paid so less is available to reinvest. There are also the taxes to be paid on unrealized capital gains. While tax-free returns on your investments were not an option in 1962, they are an option today, in a Roth IRA. The contribution limit is high enough that someone earning the average wage can contribute more than 10% of his income. So ignoring the tax aspect is a flaw only in the historical sense.

In the end, however, I agree with the main point of the book and of FMF. You should have more than $44,000 in assets (other than personal property) when you retire. And a steady (but realistic) savings rate should get you there.


Foobarista said...

Some other things:

o Taxes were much higher in those days than now, especially at the lower brackets. In 1961, income tax brackets started at 20% and went to 91%!

o Transaction costs were huge, especially before the late 1970s.

Saving $1000 into the stock market in those days would have meant saving a huge percentage of income.