When you envision your retirement, what do you see? A vacation home on the beach? Finally being able to travel around the world whenever you want? Whatever your ideal retirement life is, I bet it doesn’t involve anxiety over mounting medical bills and a dwindling cash supply. While most of us have dreams of grandeur when it comes to our retirement, few of us ever get there. Starting to invest in your retirement early gives you a serious leg up on being able to one day live your retirement dream, but the majority of us will spend our youth ignoring the enormous benefits of starting to save early for retirement, and instead spend all of our hard-earned cash on things that provide us short-term gratification.
The benefit of investing early for retirement is compound interest. Compound interest is your BFF when it comes to long-term investing because it allows you to earn interest on your interest. It works like this. If you invest $100 and earn 10% interest this year, you will have $110. Next year you’ll earn 10% interest on $110, so you’ll earn $11 and have $121. And so on. When you start investing early for retirement, you have more years to earn interest on your interest, which can lead to significant wealth generation. Let’s take a look at a real-life example.
If you start investing at 20 and invest $100 a month until you’re 60, and receive a 10% annual return, you’ll have $632,500 at 60. Only 8% or $48k of that will have been from your contributions. $584,405 will have been made from compound interest. (See, I told you it was your BFF). Let’s use the exact same scenario, but say you started investing at 30. In this scenario, by 60 you will only have $226,048. That’s a difference of $406,452 because you didn’t benefit from compound interest for 10 more years. On top of that, 16%, or $36k of your earnings will be from your contributions, instead of only 8%.
If you’re in your early 20s and reading this, you’re in good shape. Just start investing in a retirement account now. If you’re already 30 and you’re like OMG I’m f***ked! Better late than never. Start a retirement account today, and keep reading to learn how you can still reach your retirement goals. (For info on the types of retirement accounts, see this post.)
If you’re starting a little bit late on your retirement savings, you’ll have to make larger contributions, but you can still reach your goal of a fruitful retirement. Even if you start saving early, it is important to understand if your current contributions will get you to the retirement you desire. To do this, you need to figure out what you want your annual income to be when you retire, and how much you need to have invested to get that. The best way to figure this out is by calculating when you’ll reach financial independence.
Financial independence (FI) means that you can generate enough income from passive sources, like your investments, to fund your lifestyle with no fulltime job. It is usually associated with the FIRE movement. This is a fringe financial movement that has gained popularity among millennials and stands for financial independence retire early. Maybe you’re not looking to retire early, but you’re probably looking to retire at some point. Setting a goal of reaching FI by retirement means that when you retire you’ll be generating enough money through your investments to live on, so in theory, you should never run out of money. If the retirement you’re picturing isn’t one of minimalism and penny pinching, you’ll probably need to have a lot more money saved for retirement than you think you will. Calculating your FI will tell you how much you need to have invested to hit your retirement income goal, and live your retirement dream.
How to Calculate Your FI
You should start by calculating your current FI income. Figure out your average monthly spending, including discretionary spending, and multiply by 12. If you want to maintain your lifestyle, make sure you include expenses like shopping, travel, restaurant dining, etc. Literally ALL of your spending. Let’s say the passive income you currently need to reach FI is $75k/year. Divide that number by 10% (the average annual market return). $75,000/.1 = $750,000. Based on this, you’ll need to have $750,000 invested in the stock market to reach FI.
Once you know how much it costs to maintain your current lifestyle, list out the goals you have for the future. Do you want to take at least 1 international trip each year? Increase your FI income by the cost to do that. Want to shop twice as much? Increase your income amount again. Be honest with how you see your life in the future and increase your spending accordingly. Do not remove things you won’t have to pay in the future like student loans. These will probably turn into other expenses like medical bills, and your lifestyle will probably get more expensive in general as you age, not less. Now divide your goal income level by 10%, and you have your retirement goal FI.
You’re probably shocked at how much you actually have to invest to achieve this goal. If you want to have $200k to live on each year, you’ll need to have $2M invested in stocks to get that. That’s a lot of dough. So now that you know your investment amount to reach retirement FI, how can you make sure you get there?
Setting Up Your Investment Plan
The easiest way to determine if you’ll reach FI by retirement is by using a retirement calculator like this one. Start by setting all of the values at their current levels. This will show you if your current plan will get you to your goal. The average return on the stock market is 10%, so if you’re young and mostly invested in stocks, this is a good annual return percentage to use. If you contribute to your 401K, make sure to include your contribution, as well as your employer match. Once all of your values are entered, calculate your estimated retirement savings. If this number is below your FI investment amount, you’re unlikely to reach FI by retirement.
If you won’t reach FI based on your results, you can play around with your contribution amount and retirement age to see what you’ll need to start contributing to reach your goal, or when you will reach it based on your current contributions. Also, keep in mind that you’ll likely move your money into less risky investments as you age. Less risk = less reward, so you should assume that you will receive a lower return as you get older. (You can learn more about the risk/return trade-off here). Take your goal retirement income and divide by lower annual rates of return to see how a lower return affects the amount you’ll need to have invested to reach FI. Then you can play around will lower annual return values in the calculator and look at how this changes your retirement plan.
Once you figure out what your contribution level needs to be to achieve your retirement goal FI within the time frame you want, begin working toward increasing your investment contributions to that level. You don’t need to make the leap all at once, but at a minimum, you should make a plan to get your contributions up to the appropriate level. Once you’ve hit your contribution goal, you can let compound interest work its magic.
While there is no secret formula that gives you the perfect amount to have invested by retirement, setting the goal to reach financial independence by then is a great way to set yourself up to live your retirement dream. Most people set a goal to have a lump sum saved to start chipping away at during retirement. These people end up living the retirement nightmare. Penny pinching to make sure their lump sum doesn’t hit zero before they do. By setting your goal to reach FI by retirement, you’ll be generating enough passive income to sustain your lifestyle into eternity and live your retirement dream, whatever that may be.