Written by Gregory Palacorolla, CFP ®
Did you know that, according to the U.S. Census Bureau, just 1/3 of working Americans are saving money in an employer-sponsored or tax-deferred retirement account? This fact makes you wonder how many people understand the power behind automatic contributions to a retirement account, and the magic of compounding.
The good news is that for every yin there is a yang. There is growing evidence that more and more Americans are starting to catch on to this powerful strategy. There were 157,000 401(k) millionaires at Fidelity in the 1st quarter of 2018, up from 74,000 in the 1st quarter of 2016.
So, what is their secret sauce? The truth is there is nothing secret about it. They are simply exercising discipline by saving money, contributing regularly to their retirement account, and harnessing the power of compounding over time.
For example, an employee making $50,000 a year can potentially end up with $1.6 million at retirement age if you assume the following:
- Contributes 7% of gross income ($3,500) per year
- Receives a raise of 2% every year
- Employer matches half of the employee’s monthly savings
- Retires at age 67
The above example supports the findings of one recent study, according to Forbes, that those who chose to automatically boost their savings rate and were auto-enrolled in 401(k)’s saved at least 7% more than those who didn’t.
It is true, that the more money you put away, the larger the investment gains that money will produce over time. However, even if you can’t contribute the max amount needed for the company match to kick in, contribute what you can, and work your way up to a higher savings rate over time. Something is always better than nothing. The following example illustrates just how much of an impact size of contributions has:
A 25 -year old boosts his annual savings rate from 10-12% a year and as a result, would have a little less than $1,000,000 as he enters retirement. If he increases his savings rate to 15%, he would end up with just over $1,200,000, which is $370,000 more than the 10% rate yielded!
Timing Is Everything
The age you start contributing to your retirement account matters. Of course, it is never too late to start, but earlier is better. This is due to the magic of compounding.
Compounding is when an investment earns a return, and the gains on the initial investment are reinvested and begin to earn their own returns. Two individuals could put the same amount into their retirement accounts and for the same number of years, but the individual who started at an earlier age will end up having more by retirement. Here is an example:
- John puts $1,000 per month away starting at age 25 and then stops contributing after 10 years. The money just sits in his investment account accruing at a 7% rate until age 65. John will have about $1,500,000 at age 65.
- Cindy puts $1,000 per month away starting at age 45 and then stops contributing after 10 years. She too, just lets the money sit in her investment account accruing at a 7% rate until age 65. Cindy will have about $375,000 at age 65.
Both put in a total of $120,000 and both contributed for only 10 years. However, John’s account grew by $1,125,000 more than Cindy’s. That is quite a difference!
Finding the Funds
Many people want to save money to put toward retirement, but they can’t seem to figure out how. Sometimes it’s the little things that make all the difference!
- Eat out less and pack a lunch
- Find less expensive ways to have fun on the weekends
- Check your monthly bills to see if you can find better deals/rates elsewhere and apply any savings to your contribution initiative
- Brew and drink your coffee at home
Vanguard shared an excellent illustration of how much a single cup of coffee impacts your wallet over time:
- Daily: $3.50
- Monthly: $105
- Annually: $1,260
- Lifetime: $106,000
The key takeaway is that where there is a will, there is a way. Sometimes it is just a matter of taking the time to map out where the savings can come from.
Steps to Take
- Obviously, opening/enrolling in a retirement account (401(k), Roth IRA, traditional IRA) is the first step.
- Have a portion of your paycheck sent directly to your retirement account (Ideally at least 10% of your pre-tax income, but if you can’t do that much, do what you can).
- Set up auto increase (also known as auto escalation), which allows you to choose a percentage to increase your contributions by and how often.
- Take advantage of the employer match, if available. Most auto-enrollment plans set a default rate to ensure you receive the full match, but sometimes you may need to increase your savings rate to reach that threshold. More businesses are offering this to their employees. 42% of companies in 2015 who offered plans matched employee contributions dollar for dollar, according to the consultancy firm Aon Hewitt.
Implementing automatic contributions within a retirement account is a proven effective strategy when it comes to saving for retirement. Why not do everything you can to increase the chances of your nest egg growing!
Sources: MarketWatch, Money, Vanguard
© Geier Asset Management, Inc. Dec. 2018. Gregory Palacorolla, CFP ® is Director of Wealth Management for Geier Asset Management, Inc., a Registered Investment Advisor. The articles & opinions expressed in this material were gathered from a variety of sources, but are reviewed by Geier Asset Management, Inc. prior to its dissemination. All sources are believed to be reliable but do not constitute specific investment advice. The views expressed are those of the firm as of December 2018 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice. Any advice given is general in nature and investors must consider their own individual circumstances. In all cases, please contact your investment professional before making any investment choices. Geier Asset Management, Inc. is not responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.