For younger people, retirement seems so far in the future that it is difficult to prioritize setting money aside for that purpose. At the same time, people drawing close to retirement will often say that the years go by fast and creating a sufficient nest egg becomes progressively harder over time. Individuals tend to incur additional expenses such as families or mortgages as they grow older, which makes saving more challenging.
In truth, people earn less at the start of their careers. That can also become an excuse not to save enough, especially if individuals have monthly expenses like student loan payments. Regardless of the particulars of a given situation, the reality is that everyone can benefit from saving for retirement as early as possible, even if only a small amount is saved each month.
The Importance of Saving Early for Retirement
The reason that people should start saving for retirement as early as possible is simple: compound interest. The term compound interest refers to the exponential growth of invested money over time as interest builds upon itself. The best way to understand the power of compound interest is by looking at an example.
Imagine someone who invests $1,000 in a long-term bond that pays 3 percent annually in interest. At the end of the first year, that person has $1,030. However, the principal will increase by an additional $30.90 the following year. The increase is small, but imagine the process continuing for 39 years. At that point, the account would be worth $3,167 with a gain of $95 going into year 40. The initial investment has more than tripled in value with nearly $100 getting added each year.
This demonstrates the importance of saving early rather than catching up down the line. To catch up to the person in this scenario, someone starting in year 40 would need to save more than $3,000, whereas the initial investment for the early investor was only $1,000. Another example can make this concept even more clear.
Imagine someone starts saving $100 per month with an average return of 1 percent monthly. Over the course of 40 years, that retirement account would be worth $1.17 million even though the amount actually invested is only $48,000. Another person does not save early, instead deciding to put aside $1,000 per month. That person saves in this way for 10 years. At the end of that 10 years the account would be worth only $230,000 and the amount actually invested would be $120,000. In other words, the second person has “saved” more than twice as much, but has an account worth less than a quarter of the first individual.
The Key Considerations When Choosing Investments
Of course, the situations above have hypothetical rates of return. The actual growth of an account will depend on a number of different factors, the most important of which is the types of assets chosen. Unfortunately, the investments that provide the greatest returns are those with the highest level of risk, particularly stocks. Investments with a lower market risk, such as federal bonds, pay the lowest returns.
In the end, the choice of investments often comes down to risk tolerance. People who feel a great deal of stress because of the level of risk they have taken on may decide to lower the risk profile of a retirement account. While this approach will slow growth, it can provide piece of mind. However, individuals should also focus on learning more about investments because much of the anxiety associated with risk stems from a lack of knowledge.
The other factor that people need to consider is their retirement horizon, or how long before they expect to stop working. The reason that this consideration is important is related to the amount of time necessary to regain any market losses. People with decades before retirement can often put more of their portfolio in riskier investments like stocks because they have more time to recover if the market experiences considerable losses.
This points to another benefit of saving for retirement earlier. Taking on more risk results in a higher rate of return. However, this strategy is more feasible when the investor is young and has decades to wait for market recovery. In general, people become more conservative as they get closer to retirement since market fluctuations can have a greater impact on their income in retirement.
The Advantage of Employer Contributions to Accounts
The final reason to begin saving at a younger age is the impact of employer matches. Many employers will match contributions to a sponsored retirement account up to a certain amount. Since this is basically free money, individuals should take advantage of it as much as possible. Those who are younger have more years to take advantage of this free money than individuals who are older.
While people who are younger may not be able to save as much, if all contributions basically become doubled and then undergo compound interest, savers can actually build rather sizeable nest eggs with only small monthly contributions to their accounts. When considering a job, ask about employer matches and the maximum contributions. It can sometimes make sense to take a job with a lower salary that provides a match over a job that offers more money without one.