The impact of savings rates and investment rates of return.
Investors are always concerned about the returns they are receiving. How do they compare to the S&P 500? What about Apple, Amazon, and Microsoft? Many investors see the goal of investing as achieving the best returns possible, so talk consistently revolves around returns. What often gets overlooked is how much of an impact an investors' savings rate has on their ultimate account value. Suppose two individuals are starting to invest. Each has a starting annual salary of $60,000. Each invests a portion of their salary annually for 20 years* and each sees their salary increase by 4% per year during that period. Individual A, however, saves 7% of their salary every year and earns an average annual return of 5% while individual B saves 5% of their salary but earns a 7% annual return. Which investor would you expect to have a larger balance after the 20 year period? Probably pretty similar, right? *for the purposes of this exercise, each year's annual investment is divided in half and multiplied by the assumed annual return Answer: Individual A ends up with $198,966 at the end of year 20 while Individual B ends up with $173,731, almost 15% higher than Individual B. Maybe that example was more obvious to people than I am assuming, so how about a second scenario: Individual A now only receives a 4% annual return, while saving 7% of their salary, and individual B continues to receive a 7% return and save 5%. Who will end up with the larger balance now? Answer: Individual A ends up with $180,514 vs. $173,731 for Individual B, about 4% higher than their higher return peer. Individual A's annual return has to fall below roughly 3.6% for Individual B to end up with the larger balance at the end of year 20. Put another way, if Individual A saves 7% per year and returns only 3.6% annually, they end up with essentially the same future balance as if they had saved 5% per year and earned a 7% annual return. Below is a table comparing different savings rates at different rates of return for the same salary, time period, and salary growth as the above scenario:
This example is not meant to diminish the importance of maximizing your long term investment returns through a well established plan and portfolio, but serves to show that small increases in your savings rate (i.e. contribution to your 401(k) or other employer sponsored retirement plan) can have a substantial long-term impact. Tips and ideas for increasing your savings rate: * If your employer matches your retirement plan contributions up to a certain %, make sure you are contributing up to that level if you are financially able to. For instance, if your employer matches up to 5% of your salary and you increase your own contribution from 4% to 5%, the total contribution increases from 8% to 10%. As seen in the previous example, this can have a big long-term impact. An employer match essentially gets you an immediate 100% return on your personal contribution. * When you receive a salary increase, increase your retirement plan contribution rate along with it. Even if it is only a marginal increase, it can make a difference in the long run. * Treat bonuses like a typical paycheck and set a portion aside for savings. Lastly, it is important to remember to balance what you are saving and investing with what your current financial needs are. You don't want to be over contributing to a retirement plan and then struggle to cover your ongoing expenses and have to use your credit card to pay bills. Credit card debt is one of the most detrimental stumbling blocks to long-term savings and priority number one should be to eliminate that debt before increasing your retirement contribution rate or making investments outside of retirement accounts.
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