The false promise of compound interest

By Felix Salmon
February 17, 2011
contention that, when it comes to saving for retirement, "by far the most important number is the total sum of dollars that you’ve put into your retirement funds over time; the annualized rate of return on those dollars is secondary".

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A loyal reader on the sell side emails to object in strenuous terms to my contention that, when it comes to saving for retirement, “by far the most important number is the total sum of dollars that you’ve put into your retirement funds over time; the annualized rate of return on those dollars is secondary”.

Being a sell-sider, he attached an Excel spreadsheet. He assumes you start saving $6,000 a year every year from age 25 to age 60 and calculates that such a person would end up with $575,000 at a 5% return and $1.12 million at an 8% return.

But of course nobody does that. Saving is lumpy; very few of us diligently start socking away $6,000 a year at age 25. (Well, maybe those of us who go on to become investment bankers do. But no one’s worried about them.) In any case, of course if you keep savings constant, then the rate of return makes all the difference. That’s a tautology.

But much more common is the person who struggles through their 20s, brings up kids in their 30s and then wakes up in a cold sweat one morning in their mid-40s, worrying about what they’re going to live on when they retire. By that point they’ve had enough pay raises that they’re going to need an enormous sum in order to maintain the style to which they’ve become accustomed. But at the same time they’re spending everything they’re earning already. So they put away what they can and count on 8% or 10% annualized returns — or even more, if they’re investing in dot-com stocks or Miami condos — to get them where they want to be.

This, needless to say, is a strategy which is likely to end in tears. And it’s not just individuals thinking this way, either — municipalities do, too, and they really ought to know better.

My point is that the range of remotely sensible investment strategies for a working person is actually pretty narrow. You can’t just wave a magic asset-allocation wand and change your annualized return over a period of 35 years by 300 basis points. Frankly, you’d be doing well if you could improve it by 30 basis points. The market will return whatever the market will return and you will do a little bit worse than that, most likely.

So the way to have a comfortable retirement is not to think that by making a clever choice when it comes to stock-picking or investment strategy that you can somehow make up for the money you’re spending rather than saving. Instead, it’s to diligently save as much as you can, from as early an age as possible and simply invest it in a non-idiotic manner. The more you save, especially in your 20s and 30s, the more you’ll end up with in retirement.

Wall Street would love us to believe that the magic of compound interest gives us a free lunch; that a small amount of savings, if compounded at a high enough rate, can set us up for life. That might be true mathematically, but saving doesn’t work that way in the real world. Interest rates are low, now, and wages are growing sluggishly.

The three big drivers of big retirement accounts — sharply rising salaries, sharply rising house prices and a sharply rising stock market — are all looking very uncertain these days. So let’s not perpetuate this pipe dream that if only we can get an 8% return on our funds, everything will be fine. Because chances are we won’t. Absent that 8% return, the only way of getting to where we want to be is to simply spend less and save more.

29 comments

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Your quote

“Wall Street would love us to believe that the magic of compound interest gives us a free lunch; that a small amount of savings, if compounded at a high enough rate, can set us up for life. That might be true mathematically, but saving doesn’t work that way in the real world”. endquote

is accurate.

However, the reason compounding interest lags is because the billionaires get the best interest rates, and there is not enough left over for anyone else. Interest rates dividends should be reversed, higher interest rate dividends for those with less savings, less for those who have a LOT more (like millions upon millions), decreasing even more as we approach the billions, and so on.

http://wallstreetchange.blogspot.com/201 0/11/2010-after-election-4-point-economi c.html

Posted by SWARMtheBANKS | Report as abusive

Not only that, but because the billionaires are hogging the interest rate dividends, the poor are left to contend with unending double digit credit card interest rates that they can never get out from under.

Posted by SWARMtheBANKS | Report as abusive

>The three big drivers of big retirement accounts — sharply rising salaries, sharply rising house prices and a sharply rising stock market — are all looking very uncertain these days.<

And just look at how well prepared the people who benefited the most from those days are for retirement, The Boomers!!

Oh.

Wait.

Posted by dtc | Report as abusive

Could I humbly submit that you left out a factor? Time. Of COURSE if you don’t have enough time, then the amount you save will trump the rate at which you save. Higher investment returns only work if you have enough time to let them work.

But you left out one other critical factor, Felix. Higher fees that eat up any higher interest rates effectively transfer the return from a sensible asset allocation strategy from the investor to the manager. The manager gets the return, the investor bears the risk. Talk about an agency problem!

Posted by Publius | Report as abusive

Excellent article. As a retired CPA, I see a lot of people that are not doing anything for retirement. The interest rates on retirement assets is not the problem. It is the spending habits and credit card debts. Since my retirement, I am dedicating my time to make people aware of the issues in retirement.

I have a blog and newsletter on this subject. Web page is http://www.yoyoretirement.com. YOYO is acronym for You`re On Your Own for retirement planning.

Lewis Robinson

Posted by plrcpa | Report as abusive

Most people will never save enough for retirement, which is why even to suggest getting rid of Social Security is idiotic.

Posted by maynardGkeynes | Report as abusive

The most important issue is FINANCIAL LITERACY followed by TIME. The comment insinuating that investment bankers are the only ones really capable of saving $6,000 in their 20s comment is a bit below you, IMO.

People can and do choose to spend more in their 20s and 30s and they end up waking up a cold sweat latter mostly due to naivety. I would submit the real compounding is the compounding of a bad situation (not saving enough early) with chasing higher returns.

FYI his math is wrong $6,000 for 35 years @5% is $541,921 and @8% is $1,033,900. He was using 36 years.

His mistake goes to show the importance of time. Work till your 65 (40 years @5% with $6,000 per year is $724,798) This is $182,876 more then stopping at 60.

If one wants to retire at 60 instead of 65 it is their choice, but like not saving a high enough amount in your 20s and 30s you are compressing time.

Posted by david3 | Report as abusive

The uneven income stream is a good argument. The better argument is the real return on an investments. That fixed income argument above should be docked for inflation. Yields are low today largely because inflation is low; yields will be higher tomorrow because inflation will be higher. Conservative assumptions yields essentially no real return for fixed income at maturities less than five years, maybe 1% or 1.5% for maturities of ten years. Equities charitably might be able to get 4% real return, although that probably is awfully optimistic.

Given that actual real returns are very low, the most conservative assumption you can make is that money saved away will earn just enough to cover any inflation, and that’s it. Those who can and do save when they are younger are going to be better off, but the real test of retirement savings is how long you work, or more accurately, can work, at an advanced age. Each year of additional work increases savings and decreases future retirement years, so the retirement value of working at age 72 is far more worthwhile than most planning schemes, no matter how well intended.

Posted by Chiguy1001 | Report as abusive

“much more common is the person who struggles through their 20s, brings up kids in their 30s and then wakes up in a cold sweat one morning in their mid-40s, worrying about what they’re going to live on when they retire.”

Felix… the person you described is hopelessly behind where they should be. Ya ya… I know life can be messy… bad things happen to good people… time to mandate that workers put 10% of wages into a true lockbox IRA.

So many westerners are planning on harvesting and eating crops that they never bothered to plant. Those folks will politely ask the minority who did sacrifice and plan to share a bit more…

…should the answer be no they will ask again inpolitely.

Best hopes for a massive spike for financial litteracy.

Posted by y2kurtus | Report as abusive

…sharply rising salaries, sharply rising house prices and a sharply rising stock market — are all looking very uncertain these days

Once again I marvel at the ability of commentators to misdirect. The reader is left with the impression that he sort of has already — that “equities” and houses will be worth more over time than they are now. “Fixed income”? Well conceivably we can keep producing bonds (Bill Gross will be happy to help us with any of our bond-related needs), but with inflation crackling along at even the conservative 2.5% that the propagandists are pushing, are bonds really “safe as bonds”?

Real estate always increases in value! Mmmhmm.

To sum up: the nasty scenario is not that salaries, house prices, and the stock market will not rise sharply, it’s that they will all drop. You know this.

Posted by Uncle_Billy | Report as abusive

Felix, I can’t even finish reading the article… (Maybe will go back and read it again later.)

You describe the life cycle of a grasshopper. Frivolously spend money throughout your 20s and 30s, then wake up in your mid 40s with no hope of saving for college let alone retirement.

Yet there are plenty of people who approach life differently. For example, we began saving seriously when we were 25, waited 8 years to have children, and in between got in a solid five years of double-income-no-child during which we socked away close to 50% of our gross earnings. We are not investment bankers. Neither of us has ever held a job paying more than $70k in a year.

It is one thing to acknowledge that MOST people are spendthrift fools who have no concept of financial planning. It is another entirely to pretend that six-figure earnings are the only path to wealth.

The keys to wealth:
(1) Begin early. That money you save between the ages of 25 and 35 will double three times (factor of 8) by retirement. That money you save between the ages of 45 and 55 will double ONCE.

(2) Make savings a priority. Income tends to rise rapidly between the ages of 25 and 35. If all the additional income is devoted to savings, NONE to spending, then by the age of 35 you will likely be socking away 40% or more of what you make.

(3) Learn the basics of financial planning and investment management. Ignorance in this area is exceptionally costly.

By the age of 40, you should have 5x your annual earnings in financial assets. By the age of 50, that will hopefully double (investment returns help here) and your house should be fully paid off. And at the age of 60? If you have 15x to 20x your annual earnings, no mortgage, no college debt, then you are well set for retirement.

Posted by TFF | Report as abusive

TFF is spot spot on… I want to 2nd the notion that saving a big retirement nest egg pre-kids is pretty imporntant. The upper middle class can spend anything they have on enrichment activities for the kids and rationalize the investment.

As 30somethings now we make twice what we made as just starting out 20somethings… but with the mortgage, property taxes, daycare, and health insurance we both feel like we had more disposable income at 23 than 33.

While TFF’s keys to wealth 1-3 are unquestionably the first 3 things anyone should do I would perhaps put another goal out there that perhaps only 25% of people could achive but is still worth thinking about.

Start your own business. I hate people that don’t follow their own advice and I have not started my own business but 50% of the people I manage money for did. Truck drivers who bought a truck, accountants who left their firm to start their own, mechnaics who bought their own garage, and on and on.

The tax breaks afforded to small business people are to extensive to list and all my customers tell me that you work 3x as hard and 5x as smart when you’re working for yourself instead of someone else.

Work hard, play hard, learn hard, save hard!

Posted by y2kurtus | Report as abusive

Okay, came back and read it through to the end. Aside from the line, “But of course nobody does that.”, Felix has his head screwed on straight.

SOME people take planning for their future seriously, and it isn’t necessarily the investment bankers of the world. What puzzles me is why so many people DON’T. Lousy education?

Note that saving $6k/year doesn’t get you very far. That $1M nest egg in 35 years will be worth far less in the future than now. If you are accustomed to spending $40k/year, then you ought to accumulate at least $1.5M in *present* buying power, which could easily be $3M a decade from now. I guess you could (in theory) save $100,000 a year between the ages of 50 and 65, but who makes that kind of money?

Realistically, your only hope is to begin young.

Posted by TFF | Report as abusive

This was really a smart, practical post and a useful corrective to the so-called personal finance gurus like Dave Ramsey and Suze Orman (“The courage to be rich”? Really, all it takes it “courage”?) who throw up slides during their talks that show how many millions of dollars you’ll have if you save X thousand dollars per year, every year at 12 or 18% compounded interest as if it were some profound insight and not an entirely theoretical conceit.

Guess what folks? You are NOT going to be able to invest in an asset class that returns even 11% a year over an entire thirty-five year period! That is just inarguable, even the self-righteous previous commenters who have been saving for retirement since age 22 can’t dispute that. The return of the S and P 500, where one would presumably be investing one’s 401k, over the majority of the last twelve years has been negative or flat, depending upon if you account for dividends or not.

And to the self-righteous previous commenters who just think that everyone who hasn’t started saving at age 22 is stupid and doesn’t understand personal finance or is just a spendthrift, consider this: if even a medium-sized majority (say 75%) of people started saving substantially more for retirement and earlier, macroeconomically speaking all that would happen is that the AD curve would shift to the right and the price level of things that people need in retirement (rent and owners association dues at assisted living facilities, health care costs, etc.) would rise such that the marginal amount saved would be eaten wholesale and the median retiree really wouldn’t be that much better off.

Posted by Strych09 | Report as abusive

Strych09, if you’ve been around here long, you know I’m aiming (hoping?) for a 3% real return on my portfolio… Absolutely NOT arguing that investment returns will make up for a shortfall in savings. Did you think I was? It is still very important to start early.

Self-righteous? Guess it takes one to know one. But if you spend everything you make in your 20s, it is going to be really difficult to start saving in your 30s (especially if you have kids). And unless you have an exceptionally high income (which you might, but I don’t), then waiting until you are 40 or 50 to start saving for retirement is too late. In that case you had better hope that Social Security is generous.

You do make an interesting point about societal-level shifts in saving habits. At least it would be interesting if you thought it through the whole way. In response to your limited argument, however, a shift in the demand curve for a specific service does not always result in a significant increase in price. This is especially true in situations where there is substantial economic slack — and the Fed is now talking about “natural” unemployment in excess of 6%. If retirees were wealthier, it would simply shift greater societal resources towards the services they demand.

Moreover, the domestic economy is not even close to being a closed system. Both investments and trade now have global reach. Any argument along these lines must be framed in terms of the global economy, and all indications are that wages in the US (and thus the cost of nursing-home care) are likely to comprise a SMALLER portion of the global economy in the future than they do today.

Finally, I don’t see 75% of the people saving aggressively throughout their adult lives. If they did, it would certainly have broad implications for the US economy. Would all of them be negative? Are you arguing that it is GOOD that our country is buried in debt?

P.S. I hope to be able to retire early enough that I can enjoy a few years of freedom before being forced into an assisted living facility. YMMV.

Posted by TFF | Report as abusive

To elaborate on the interesting point that Strych09 hinted at…

Investment flows are related to the age of the investor. A younger investor will likely be putting money into stocks. An investor nearing retirement may be shifting money from stocks into bonds. In retirement, all investments get drawn down. If you have a large number of people all following the same curve, then you might expect a “moving bubble” with diminished returns for everybody in that generation as they move en masse from one asset class to another.

Definitely an interesting idea, somewhat plausible, but should we expect to see that in practice with the Baby Boomers? My guess is that the generational allocation shifts are too small relative to the international investment flows for that to make much of a difference. The fear/greed mood swings (which cross generations) likely involve more people moving together than the retirement of the Boomers (which will be spread out over 20 years).

If the theory does have any validity, however, it ought to be good news for anybody on a counter-cycle. Certainly the last decade has been a great investment climate for anybody actively adding to their savings (run some numbers using DCA and constant allocation targets rather than simply looking at the market endpoints), despite being a horrid situation for those who are already in or near retirement.

Posted by TFF | Report as abusive

Interesting (but hardly surprising in today’s consumer culture) but nobody has mentioned not taking on debt as a means to future riches. The money that would otherwise be spent on interest can be used for greater things. Credit cards are bad for your bank balance, bad for your savings, and bad for the economy.

A 20% taxpayer has to earn 20% on savings to pay off 16% credit card interest. Dividing your total credit card debt by your monthly disposable income shows you how long you would have to save it for to have accumulated the same things without debt (and therefore cheaper). Not only that, but cash purchases usually give you a discount too.

Get in debt, stay in debt; avoid debt, feel richer, be richer.

Posted by FifthDecade | Report as abusive

TFF, I agree with you that it is “very important to start early”, but that supports Felix’s point that in the real world, very few normal working people have enough time to save an adequate amount for retirement regardless of asset class that they choose to invest their savings in.

When I was 25, I was still (horrors!) paying off substantial student loan debt and didn’t have the remaining income to start paying into a 401k or IRA. I applaud you on your frugality and ability to start saving and investing early, but I don’t think it’s a mystery as to why most people don’t do it, nor do I think that “MOST people are spendthrift fools who
have no concept of financial planning” (this is where you leave yourself open to the charge of being ‘self-righteous’, shouldn’t retiring early and comfortably, in your case, be it’s own reward?) By the time you’re (or the aforementioned financial gurus) telling someone that they “should just start early”, it’s usually too late.

The standard of living for working americans is falling in real terms, and although I agree with “FifthDecade” that taking on debt is a way to financial folly and should be avoided at all costs, I think that Raghuram Rajan has made the case pretty convincingly that the way the economy has provided americans with a soft landing is through increased debt provision. So it’s not just the matter of “frivolous” spending in one’s twenties that you make it out to be.

Posted by Strych09 | Report as abusive

And TFF, As to your rhetorical questions, I don’t think that all the broad implications for the US economy would be negative if people started saving earlier and more aggressively. I also don’t think too highly of our “postmodern” consumption-based economy.

Posted by Strych09 | Report as abusive

TFF: DINKs making $70k/year each are pretty wealthy. Some people can’t make that much. Some people have kids sooner (you could attribute this to stupidity or you could attribute it to concerns about infertility/making disabled kids by waiting). Some people have careers that are derailed by kids. Some people don’t find a compatible partner that young. Some people get sick, get divorced, or lose jobs. Sorry, your luck is a lot more significant to your current position than your virtue.

Posted by najdorf | Report as abusive

Strych09, read back to the original article and you’ll see the rather outrageous line, “But of course nobody does that. [...] Well, maybe those of us who go on to become investment bankers.” I definitely overreacted in response, but “nobody does that” is a pretty strong statement and “of course” doesn’t in any way soften it.

najdorf, we’ve never had a SINGLE job paying more than $70k. The total AGI through our 30s was never more than $100k (and that figure is boosted by working weekend jobs). You can make a strong case that a household income of $90k-$100k with two kids is “wealthy”. I agree. But no matter HOW much you earn there is always somebody wealthier than you and always somebody less well off. If you pattern your lifestyle after those who are one step less well off, then you can find savings. Likewise, if you pattern your lifestyle after somebody who is one step wealthier, you will end up deeply buried in debt.

I very much understand that circumstances and luck differ. My students do not come from privileged backgrounds, so I see and work with this daily. Student loans are a terrible burden, especially because (with the time value of money) they are incurred so early in life. Just last week I proposed greater funding for the public universities for the express purpose of REDUCING the student loan burden on our youth. Give them a quality, fully-funded alternative to the private colleges.

Finally, virtue is described by one’s actions in life, not by one’s bank account. I’m not sure why people are confusing the two. Failing to plan for your future is short-sighted, since I fear the social safety nets of this country are about to be shredded, but it isn’t sinful.

Posted by TFF | Report as abusive

“The standard of living for working Americans is falling in real terms.”

Absolutely agreed, and this is what worries me the most. The Baby Boomers were born, grew, and worked during a 50 year economic boom, extending from the end of World War II (when the US was the only major economy in the world not destroyed by the fighting) through the technological innovation of the 80s and 90s.

I have not yet had a chance to read Rajan’s book (not about to spend $20 on a copy for myself, and the library copies have been on continuous hold), but from what I gather he makes some excellent points. The US economy was showing some serious cracks in the late 90s, and without extensive borrowing to prop things up might have taken a pretty hard landing during the bursting of the dot-com bubble.

But now where do we stand? Not only did the economy not crash between 2000 and 2007, it wasn’t even permitted to EASE substantially. So the inevitable correction remains in our future — less whatever setbacks we’ve adjusted to over the last three years.

Economic systems are a somewhat-artificial convention, designed to direct the production and consumption of goods and services. We know that somebody will end up seriously bloodied as the imbalances are forcefully corrected, but the total damage done depends on our ability to improve productivity while the distribution of the damage depends on political choices. Unfortunately those elements are in somewhat of a tension, with the “compassionate” political choices likely resulting in lower growth while the “business friendly” political choices leave much to be desired socially.

Posted by TFF | Report as abusive

So, nobody thinks debt is a problem for savers? Nobody thinks it hurts the economy or fuels inflation?

Posted by FifthDecade | Report as abusive

On the contrary, FifthDecade, we’re all in this together. The savers will pay the most, because they’ll have the most to spare. But what is the alternative? Not saving isn’t going to improve the situation either personally or for the nation as a whole.

There may also be a counter-trend benefit to saving when others are spending. The economic boom that has done nice things for investment accounts over the last 25 years was fueled by debt.

Posted by TFF | Report as abusive

As luck would have it, never having had to bear excessive healthcare burdens, being still happily married after 44 years, not having to raise kids until I was in my 40′s, and having been blessed with the ambition to work my way through an excellent technical education without incurring debt, I now approach my 80th year in pretty good financial shape.

But I never paid much attention to financial planning. I have a deep mistrust of money, financial markets, and the calculations of economists and planners. Such calculations only work in a predictable economic and political world, which we in the U.S. have enjoyed from 1946 through century’s end, but which looks more and more like it may terminate soon.

Instead, from about age 30 on I decided to follow the strategy of my European ancestors, who believed that value is in land, not money. I first bought a livable house at a cheap price (away from congestion) outside a growing city. Instead of a savings account I paid down the mortgage; the idea was to acquire equity in real estate. I enjoyed my job as an engineer but never saw it as a road to riches and never intended to stay with any single employer, moving “up the ladder”. As I moved to better jobs in more prosperous areas I followed the same strategy of buying bargain (but livable) homes in good areas and keeping the mortgage low.

My final house investment, in middle age, was in a semi-rural area outside a massive metropolis where I could buy a 1-acre lot with a brand new 3-bedroom house for the princely sum of $80,000. There was not much else besides a gorgeous view of 8,000-foot mountains, access to a private water company, and decent soil for planting lots of trees and potentially a productive garden.

Since my savings plan didn’t involve saving cash, worrying about rates of return, or playing the markets, I was’nt concerned about the size of my income as long as I could provide comfortably for the family and pay down the mortgage, so I took whatever employment I could get in the new location, which turned out to be straight-commission real estate sales.

This proved interesting enough and a relief from engineering drugery, and as time went on I learned how to work profitably for myself instead of under a boss’s thumb. I also ran into opportunities to buy rental units for practically zero investment. Although I never earned over net $40,000/year in my life (thus keeping me out of high tax brackets) I built up a significant retirement nest egg in the form of rental properties with very low mortgages that now bring in a steady income which can keep up with inflation. .

I still live on the same 1-acre property which now has a 1/3 acre private park (80 foot pine and oak trees) and a rental guest house whose income pays for landscaping upkeep, utilities, taxes and insurance. I have effectively no mortgage and pay very low property tax on the original 32-year old value, giving me a positive cash flow on my home! The neighborhood has matured, and because it’s in the foothills away from traffic, is now dotted with custom-built mansions appraising (even today) at over 1 and 2 million $. I still work, mostly on the property, but also at my part-time computer consulting business, not because I have to, but because it keeps me from aging more rapidly physically and mentally.

All of this is NOT meant as a brag, and obviously not as a strategy suitable for everyone, but rather as description of an alternative to prevailing American career practices, such as: attempting to climb the employment ladder with it’s inevitable psychological stresses that slowly kill (high blood pressure, obesity, etc); attempting to save dollars in bank accounts or in dollar-denominated investments which you can’t possibly control because you are too busy; and ending up with a huge mortgage, car payments, the inevitable credit-card nightmare, and spoiled kids.

The foregoing destructive practices were promoted largely by leaders of the Baby Boomer generation. Few Americans lived that way before WWII (many couldn’t even if they had wanted to). Apparently later generations haven’t learned the lesson yet.

I don’t pretend to know all the answers, but if any young person is looking for an opinion, here it is: don’t avoid financial markets, but approach them only with great caution; instead, invest primarily in things that can’t suddenly disappear but can produce reliable income on their own, like well-located land (with low debt) or a recession-proof business or profession; and don’t be afraid to strike out on your own rather than tie yourself permanently to somebody else’s enterprise.

Of course, if you happen to be very very smart, a talented politician, supremely ambitious, and not too ethical, you may freely disregard this advice and get rich quickly.

Posted by lexus | Report as abusive

Felix, Thank you for the interesting article.

May I direct you to two research articles I’ve written which I think are relevant to this topic?

Forthcoming in the Journal of Portfolio Management (Fall 2011) is an article about the “portfolio size” effect, which indicates how vitally important the last decade before retirement is. To understand this, just consider the portfolio growing at a constant percent growth rate. It may be $1 million, at retirement, but 10 years earlier it might still only be around 400k. If you experience a bad decade just before retirement, well that is a big problem.
http://ideas.repec.org/p/ngi/dpaper/10-1 1.html

Second, I just finished an article this month about the “safe savings rate”, which is the lowest savings rate from rolling historical periods that would have provided you with enough wealth at retirement to finance your planned retirement expenditures. There is not a universal safe savings rate, it needs to be calculated for a person based on their life circumstances. But in this framework, if you are following the safe savings rate, then the actual wealth accumulations and retirment withdrawal rates become less important.
http://ideas.repec.org/p/pra/mprapa/2879 6.html

Thank you.

Posted by wpfau | Report as abusive

wpfau, your article on the “safe savings rate” is very interesting and makes a ton of sense. Put another way, the S&P500 has doubled over the past two years (and thus account balances have gone up). Is an investor aiming to fund retirement twice as wealthy today as she was two years ago? Past returns and forward returns move in opposite directions.

(I believe there may be some typos in the table on page 15? Duplication of numbers in the 70% replacement rate section… But that is a minor issue.)

My greatest concern is that the next fifty years might be weaker than the last century. It may seem like you are dealing with a large amount of data, however you are looking at ~60 year slices of a single century. They are clearly not independent of each other, which begs the question, “What if the US economy faces greater challenges in the 21st century than it did during the 20th century?”

You suggest that a 30 year flat-contribution savings period requires a 16%-17% savings rate (50% replacement for a 30 year retirement). But if long-term growth is weaker, the required savings rate will be much higher. Felix regularly worries about zero real returns — and while I believe he exaggerates this concern, my own estimates suggest they will average in the 2% to 3% range for the portfolio you study. Is that enough to float this boat?

Posted by TFF | Report as abusive

TFF: Thank you for the comments. You did indeed find a typo! I’m out of my office, so I’m not sure of the precise correction, but I will fix this as soon as possible. Thank you.

Regarding your concerns about lower future returns, I am completely on board with you. I discuss this some in the section, “Potential Tragic Consequences of the Traditional Retirement Planning Approach” on page 12.

Another paper I’ve written which explores this concern is:

“An International Perspective on Safe Withdrawal Rates: The Demise of the 4 Percent Rule?”
http://www.fpanet.org/journal/CurrentIss ue/TableofContents/AnInternationalPerspe ctiveonSafeWithdrawalRates/

As the U.S. enjoyed an amazing century for asset returns relative to most of the other 16 developed market countries in the dataset I explore.

Thank you again! Wade

Posted by wpfau | Report as abusive

Discussion regarding compound interest is only really relevant with respect to credit, in which case, the promise of compounding interest is not false.

For most people, the largest percentage of their wealth is tied up in their home. And, for most people, they have a significant mortgage to match. Compared to equity markets, interest rates are stable. Net wealth can be increased by reducing debt while holding savings constant. Accordingly, paying a mortgage is saving. Gains are made not in extra earnings but reduced interest expenses by paying down the loan early. Most people are more likely to achieve this through the discipline of regular repayment. Fail to make payments and the power of compound interest will wipe you out.

Simplistically speaking, when it comes to establishing strategies for building up wealth in equity markets, dollar cost averaging is a more useful concept.

Posted by Galician | Report as abusive