Most people (especially financial planners and pf bloggers) make the idea of retirement savings much too complicated talking about index funds, 401ks, and compound returns. Many people blank out and simply follow the well-intended advice without questioning these experts. However, it is really not that difficult.
The quintessence of saving is to spend the money while not working. Thus if you work for a month and save half your income, you can take the next month off. That should be obvious. So …
If you save 5% if your income, you can take 1 year off every time you work 19 years.
If you save 10% of your income, you can take 1 year off every time you work 9 years.
If you save 20% of your income, you can take 1 year off every time you work 4 years.
If you save 30% of your income, you can take 1 year off every time you work 2 years and 4 months.
If you save 40% of your income, you can take 1 year off every time you work 1 years and 6 months.
If you save 50% of your income, you can take 1 year off every time you work 1 year.
If you save 60% of your income, you can take 1 year and 6 months off every time you work 1 year.
If you save 70% of your income, you can take 2 years and 4 months off every time you work 1 year.
If you save 80% of your income, you can take 4 years off every time you work 1 year.
If you save 90% of your income, you can take 9 years off every time you work 1 year.
Interesting, indeed! Of course normal retirement plans use savings rates less than 20% and depend on something called the “magic of compound interest”. Now there is nothing magic about compound interest, which is simply exponential growth, but there certainly is a great deal of magic associated with determining the input parameters of investment returns and inflation. These input parameters, particularly when extrapolated over large time intervals (anything more than 10 years), crucially determine the end results.
Now this kind of magic is good in theory, but sometimes it is difficult to implement in practice. Capital assets (aka tools, incidentally, you should really click on that link and read that post if you have not done so already) will give superior returns if but only if the assets are purchased at a good price and only if the assets actually improve efficiency. It is easy to find examples of investments that were purchased for much more than their worth (are you paying too much for the in my opinion totally overhyped index funds? You probably are. How do you know? If the P/E of the index is higher than 18, 1.5 times the generational average, you definitely are! Currently, the value is around 17 which corresponds to an earnings yield of 5.8%. This means that future returns are not going to be as impressive as historical returns. Another problem is the reigning economical philosophy. What is the purpose of a company? Is it only to maximize shareholder value? The shareholders certainly think so. But what about the company’s effect on the workers, the consumers and the nation as a whole. If those values change, returns will change.
Therefore you gotta ask yourself a question: How much of your retirement strategy is based on things, like your savings rate, which you can control, and how much of your strategy is based on things, like the future return and inflation rates, which nobody know and which are out of your control?
Originally posted 2008-09-11 06:53:16.