Yahoo Finance What Matters More: Saving or Investment Performance?
The millennials are not the first generation that has struggled to save in the post-pension era.
With the oldest baby boomers turning 70 next year, a new survey from the Insured Retirement Institute is yet another reminder that boomers' retirement accounts are woefully underfunded.
Among other findings, the IRI reported that only 19 percent of boomers have $250,000 or more saved for retirement, while 4 in 10 have nothing saved.
As people in or near retirement become aware of their own savings shortfalls, they sometimes try to boost investment returns by taking on more risk. Anxiety drives them to track day-to-day market movements, an activity that often creates even more stress.
Greg Ward, think tank director at financial education firm Financial Finesse, in El Segundo, California, says many Americans don't understand that if they start saving early, they won't have to play catch-up later. He finds himself having conversations with people near retirement who suddenly want to invest aggressively after years of neglecting to save.
"There's this idea that at some point, you can just flip a switch, decide to invest and you'll get this great return and make up for lost time. But that's without a full understanding that a 10 percent return on $10,000 is not the same as a 10 percent return on $100,000," he says.
He notes that savers who start early benefit from compounding. In other words, the earnings in the retirement account are reinvested to generate earnings of their own. Over time, it's a powerful way for investors to increase their account value.
But late-starting investors won't see the effects of compounding quickly. "It's hard to tell someone who's only saved $100,000 or $200,000 that even if they get a 15 percent return for the next two or three years, it won't make you a millionaire," Ward says.
Increasingly, financial advisors are focusing on behavioral components of the retirement-savings process. Faced with debt payments and other expenses, many workers forego employer 401(k) plans or save very little and miss the opportunity for investments to compound over time.
In a 2013 survey by J.P. Morgan Asset Management, 49 percent of 401(k) plan participants said paying monthly bills was their top financial priority. Saving for retirement was a distant second, with 18 percent of respondents calling it their top priority.
James Brewer, principal at Envision 401k Advisors in Chicago, says behavioral impediments to saving often go beyond basic bill paying. Earlier in his career, at another firm, he helped a client set up a retirement savings plan.
However, the client didn't make the scheduled contributions. When Brewer saw him several months later, the client explained the lapse by telling Brewer about a new luxury car he'd purchased.
Brewer observes that people also tend to think about their financial obligations in sequence. While it's not ideal from a retirement-planning perspective, the thought process often makes sense, at least on the surface. "People want to buy a house, then fix up the house they bought, then they have children, then there's the kids' college. It's just the order of things. After their kids finish college, people say, 'Now I can think about retirement.' So there's a logic to the reason why people don't save much until later, when the goal appears to be closer," he says.
To address this linear approach to financial goals and illustrate the concept of compounding, Brewer created a chart to show clients the value of saving $5,000 a year for 20 years. His hypothetical portfolio was a basic mix of 50 percent stocks and 50 percent bonds. Given average market returns, he found that this portfolio would generate about $232,000 over 20 years.
He then shows clients what would happen if they saved for 20 more years, which would be a plausible scenario for a worker who began saving at 25 and faithfully invested $5,000 every year until he or she turned 65. In that case, Brewer says, a simple 50/50 portfolio would have generated about $1.2 million.
That demonstration tends to be eye-opening, he says. "Most people don't perceive compounding. Nobody automatically believes it's such a difference," he says.
Jason Hull, founder of Hull Financial Planning in Fort Worth, Texas, uses an example to explain the benefits of compounding and saving early rather than later in life. "The math favors saving more much more heavily," he says.
His hypothetical example begins with two people, each making $75,000 per year, with an annual 3 percent increase. He then shows two extreme examples of savings and returns to illustrate his point. The first person saves 1 percent and gets a 10 percent investment return. Meanwhile, the second person saves 10 percent and gets a 1 percent return.
The higher rate of savings, even with a lower return, trumps the other plan. "It's pretty easy to figure out that person B starts out ahead. How long does it take person A to catch up and surpass person B's accumulated investments? Forty-six years," he says.
Ward says when he and his colleagues hold workshops for employees at clients' firms, they emphasize that investing is a long-term proposition. Not only should investors avoid reacting to daily market movements, they need to leave their money invested for as long as possible.
"If there's just one thing that we can help our fellow citizens to understand: Investing is, by definition, a long-term endeavor," he says. "So you don't really care what stock market is doing today or what it's doing next week or next month or a year from now. But it does matter what happens over a five-, 10- or 15-year period. Successful investors are not the ones who choose a successful investment. They're the ones who stay invested."
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