The false promise of compound interest
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 youâ€™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.