Some people say we should plan for the worst and hope for the best. With retirement, I think we should plan for the best and hope for the best. When I hit my golden years, I don’t want the stress of work to be replaced by the stress of paying bills. That doesn’t sound very relaxing!
Many people don’t plan well for retirement and a lot of people give away free money (yes, you read that correctly, FREE money!). According to the Employee Benefit Research Institute (ERBI), only 40% of employees participate in employer-sponsored programs and the average savings for a person under the age of 35 is $6,306. This is what I mean by giving away free money – the other 60% are missing out on employer matched contributions and the younger people are missing out on significant compounding interest by not contributing more.
Let’s take Sally as an example. Sally makes $30,000/year but doesn’t contribute to her 401k plan. The most frequent company match is 50% up to 6% of pay (i.e., if you put in 6%, your employer puts in 3%). Sally’s employer is average so this is what they offer. If Sally is 30 and doesn’t plan to retire until she is 65, she is missing out on $31,500 of free money. This doesn’t even include the compounding interest that money would generate.
What is compounding interest? It is the interest that interest earns. Let’s say Sally decides to contribute $2,700 to her 401k every year ($1,800 of her own money and $900 of her employer’s money). The interest from her first year of contributions would almost quadruple from $108 in the first year to $410 when she retires at age 65. This is how the compounding interest works over time:
- Year 1: $2,700 * 4% = $108 interest
- Year 2: $108 + 4% earned interest = $112.32
- Year 3: $112.32 + 4% earned interest = $116.81
- Year 35 = $394.03 + 4% earned interest = $409.78
This example is only for that very first year of interest. If Sally contributed $2,700 every year for 35 years, she would invest $81,000 of her own money but she would end up with approximately $200,000 because of compounding interest and matching from her employer. The point of this example is: invest early and take advantage of employer contributions.
If you don’t currently contribute to a 401k or contribute enough to take advantage of your full employer match, it can be a big adjustment to add in those extra deductions every month. My recommendation would be to phase in the investments over time. It will be a lifestyle adjustment to “lose” that monthly money, but it is an investment in your future. It is the same as when you start an exercise routine or improve your eating habits. It is hard to find the time to exercise or prepare healthier meals, but it is an investment in your life that you won’t regret.
When I started contributing to my 401k, I didn’t take full advantage of the match (if only I knew then what I know now!). I increased my 401k match over a few years. If I got a raise, I would increase my 401k contribution by 1% and pocket the rest of my raise. I also decreased my match for a few years after I bought my townhome because I needed the extra money to help with living expenses.
One common misperception I have heard since the big crash in 2008 is that the stock market isn’t a good investment so there isn’t much point in contributing to a 401k. The first issue with this perception is that investing in a 401k doesn’t necessarily mean investing in the stock market. You can select the percentage of your 401k that goes toward stocks versus bonds.
The second issue with this misperception is the stock market is a good long-term investment, which is what is most important for retirement savings. If you look at the stock market performance over the past 5 years in the chart below, it doesn’t look like a good investment because we aren’t even back to 2007 levels yet.
However, if you look at the stock market performance over the past 30 years in the chart below, it looks like a great investment. Black Monday, the stock market crash in 1987, looks like a tiny bump in the road.
I planned to write this post about different ways to save for retirement so I guess I will need to do a follow-up post about other options! Watch for that post if your employer doesn’t offer a 401k plan.
How do you envision your retirement? Do you plan to travel or retire to a nice cabin on a quiet lake?