Time is on My Side
Hi, everyone. Recently, I wrote about the importance of understanding Social Security’s role in determining one’s retirement picture. As I thought about this trend, another issue with it is that leads to despair in some that they may have waited too long to have a decent retirement. (After all, if someone is ten years from retirement,Social Security won’t be there as the doomsayers say, and one needs 75% of income to survive, this is going to be difficult, if not impossible.) With that being said, I don’t want you to think that I am against investing in your retirement. I have an IRA, and I think that these are vital programs to add to, but not replace, Social Security in order to build a stable retirement income.
Now or Later
Dave Ramsey argues that the most important thing that someone should do is pay off all debt except for home ownership (mortgage is something that can wait in his formulation and payments should simply be made until other things are taken care of). Once this happens, one should take all of that debt money and then start to build for retirement. He says that this is so vital that one should use every spare penny for this purposes even going so far as refusing a matching funds from a 401(k) because he feels that the key to financial freedom is a total focus on each part of the plan. However, most investment advisors argue that the most important thing to do is to pay yourself first. I’ve seen some say 15 or 20% is what is required, and others that say that 10% will do the trick. (I personally think that the answer to this question depends on the age of the person building the account.)
The ultimate problem with this way of thinking is the way compound interest works. Ultimately, when one is truly financially independent, the best way to make money is to get out of the way, and just keep breathing. In his book The Slight Edge, Jeff Olson gives an example of compound interest working for someone vs. against someone. He gives as an example a story of two friends at the age of 24 who decide that they want to invest $2000 a year into an IRA that has a yield of 12%. They decide to invest until they have enough money that they will have $1 million by their 66th birthday. The first friend starts right away, and he makes the annual $2000 investment every year for six years. He stops because he already has enough in savings to get to his goal. The second friend finds out about this at the age of 30 and decides that he’d better get started after putting it off. He finds out, much to his shock, that he will have to invest for thirty-three years in order to get to $1 million by his 66th birthday.
But what happens if someone decides to keep investing? My wife and I each have money in an IRA. I have a little bit more because I started six months earlier. We have decided to, as long as our health permits, hold off until the age of 67 (our full retirement age) to start cashing in our IRA. However, I turn 67 in October 2046, and she turns 67 in February 2054. Based on the kind of money that we should be able to earn right out of college, I did some math and decided to see what happen if I invested at $350/month and she invested at $200/month out of college, if we both invested $50/month until then. Well, by the time I turn 67, I would have over $1.9 million in my IRA. This isn’t a bad amount. However, by the time my wife turns 67, even investing 30% less than I would, she would have a total of a little more than $2.7 million in her account. This is basically the difference between investing for 36 1/4 years vs. investing for 43 years.
So, what does that mean about debt reduction? I think that debt reduction is a good thing, but it has to be a part of the total picture of financial health. Flipping through the TV over the weekend, I saw Suze Orman talking to someone who was amortizing her house to the tune of an extra $1500/month in order to pay it off a lot sooner. Suze said that her goal was noble, but she noted that she wasn’t putting nearly enough money in her IRA because of this strategy. Granted, the “get rid of all your debt first” strategy I mentioned above excludes home ownership, but this means that it is operating at the expense of time. I know, using myself as an example, that I will have a lot of student loan debt, as will my wife, once we get out of school. If it takes us five years of laser focus to get rid of our debts, and we hold off on building our IRA’s, how would that look? If we simply held onto them for five years and invested the same amount, my IRA would be less than $1.1 million, and my wife’s would be less than $1.7 million. So, combined, those five years of staying on the sidelines would cost us a total of $1.8 million. How much would our monthly payment to our IRA have to be in order to make up for those five years on the sidelines? My $350 monthly contribution would have to go to $646, and her $200 contribution would have to go to $341.
I think that this as an example of a good idea that goes too far. Debt reduction is good, but there is a reason why people like David Bach, George Clason (in The Richest Man in Babylon) and Suze Orman advise you to pay yourself first. The other advantage to starting young is that the farther out you are, the more you can afford to take risks that lead to higher yields (example: my IRA is 89% stocks, and my wife’s is 91%) which adds even more importance to the value of time.
How do you make time work for you?
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This entry was posted on Friday, July 29th, 2011 at 4:43 pm and is filed under Business. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.