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Saving For Retirement Doesn’t Work!

A young couple is sitting down with their financial planner. He tells them that for every $100 a month for the next 50 years, at only 8 percent compounded interest, they’ll have over a third of a million dollars 40 years later!

The young couple, never having really thought about this before, squeal excitedly, sign on the dotted line, and have pleasant dreams with sugarplums and secure retirements dancing in their heads.

But alas, it is not to be. They’ve been had. Or more to the point, they’re just missing a pieces of the puzzle larger than the compound interest that they are trusting to grow their nest egg.

Management Expense Ratios

Sure, the broader stock market has provided a historical gain of an average of 8% per year, but that’s the market. That’s not the mutual fund the financial planner is selling. His funds are going to charge you a management fee of at least 1.5%, probably more like 2%, and that’s regardless of whether the fund actually made any money or not. Market does 10%, you make 8%. Market loses 5%, you lose 7%. Hear that? That’s the sound of those projected profits dropping by almost 40%.

Diversification of Asset Classes

If anyone learned anything from their elders in 2008-2009, it’s that as you get closer to retirement age, you want to be reducing your exposure to high-risk assets like stocks the closer to get to retirement. The 2008 crash was just a blip on the radar to a 30 year old, but to someone who was right at retirement age, being 100% in stocks would have been disasterous. As such, as one gets older, they need to shift their money into less risky places like bonds, which also cuts the average rate of return. If we cut the overall rate of return by 1.2% each decade, you go from 8% in decade one, 6.8% in decade two, 5.6 % in decade three, and 4.4% in decade four, well… there’s that sound again. Expect another 40% drop from that 8% projection at the beginning over a 40 year period.

Taxes

Odds are that your retirement savings are going into some kind of tax-deferred account, which is a good thing. Better to get the effect of compounding before taxes eat up a big chunk of it, and also to pay tax on that money when you don’t have a normal income pushing you into a high tax bracket from dollar one. Strange as it may sound, this is actually the smallest drain on your returns when handled effectively, but it is still going to eat up 10-20% of your gains, whatever that works out to after your management expense ratios and declining tolerance for risk as you get older have eaten into your returns.

Inflation

Unfortunately, we saved the biggest drag for last. Why is it so big? Because inflation works at a steady percentage per year, just like compunding returns. But in reverse. You made 8% last year? Great. But those dollars you made are now 4% less than at the beginning of the year, as well. And just like the management expense ratio, inflation hits the entire egg, not just your profits.

Sooooo..: 8% to start… management expense ratio of 2%, inflation of 4%… down to 2% profit… reduction of risk/return over time…. taxes on whatever’s left…. you can see where this is going.

And so that poor young couple save away chip away, throwing money into their financial planner’s mutual fund, having children and living life, without a care for their retirement, for that’s all taken care of. Or so they thought.

Until somewhere around their 50th birthday, when they look at their retirement account statement, and realize that while the number on the statement goes up, it’s not nearly as fast as they had expected, and the buying power of the money they’ve been socking away hasn’t changed much from those original $100 contributions. In fact, it’s probably shrank.

If you really want to have an on-time or early retirement, you’re going to have to change a variable or two. Inflation is out of your control. As long as we live in a democracy, we’re going to have leaders that spend waaaay more than they take in to curry favor with voters and maintain power. It’s not going away. Ditto for taxes, although at least you can reduce them to some extent with a good accountant or a good tax education. Which means the variables open to you are the amount you contribute, and your rate of return.

If you think you, as a 70 year old, would spend $2,000 a month in this day and age, that’s more or less what you have to put away on a monthly basis given today’s typical rates of return from a financial planner’s mutual fund. And that means a level of savings (50-70% for most) radically beyond what they’re willing to contribute.

Another solution is to up your rate of return. But doing that involves ratcheting up your level of risk considerably, unless you educate yourself as to where those risks come from, and are able to mitigate them. But that requires education. And you’re probably going to have to do it yourself.

That’s where this blog comes in. Because just like secondary school and university/college, about 90% of what you learn there is either useless or flat out wrong… but that 10% of real information is solid gold. Problem is, we have no idea which is which while you’re learning.

I do. I’ve been there. I’ve made the mistakes and successes, and learned the lessons. I’ve never worked more than 2 weeks for someone else in my life, while coming from a underprivledged background. The lack of that steady income has advantages and disadvantages. You have an advantage over me in that you count on a check showing up every couple of weeks. You have a steady stream of income to play with. My advantage over you is that I have the time and energy to learn about how inflation and MERs and taxes and compound interest and investing really work. And I use and abuse that knowledge every chance I get. It’s allowed me to build up an asset column well above and beyond what 90% of people my age have.

So let’s team up, you and me. You still have to do your learning, but I can point you in the right direction so you can use and abuse the powerful knowledge to get a step ahead.

I think this will be the start of a beautiful friendship.

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