Sunday, July 4, 2010

How to Think About Saving

Saving is easier if you think of it an opportunity. Each dollar you earn is part of your finite lifetime income. While most people don't reflect on the finiteness of their lifetime income--the finiteness of their monthly income is painful enough--you do have a limited lifetime income. Each dollar spent represents a saving opportunity lost. You can't save a dollar spent. It's gone forever. You can earn more dollars in the future. But those dollars further reduce your finite lifetime income. You can't earn more dollars and still have as much future income as you previously had.

Yes, you can work longer than you expected. That appears to increase your lifetime income. But it's really an illusion. The reason people work longer is usually because they didn't save enough (including enough to compensate for market volatility as well as day-to-day retirement needs). So, all along, even though they didn't realize it, their habits and lifestyle doomed them to work longer than expected. Their expectations changed, but not the finiteness of their lifetime income. The only thing they might have gained, perhaps, is greater self-knowledge.

If you save nothing during your working years, you can look forward to retirement on Social Security. Most people think old age and eating dog food are incompatible. But if all you have is Social Security . . .

With the financial crisis of 2007-08 and the Great Recession, many now have the savings jones. Stocks rose, but are falling again. Real estate fell and now is stagnating. If you don't save, your net worth can go negative on you. The savings rate in the U.S. is around 4% of disposable income (i.e., the amount of earnings you have after paying income taxes). This is low by the standards of the last 100 years. But it's the highest savings rate in most of a generation. While some months, Americans seem to waffle on their newly found prudence, the slow economic growth and high unemployment levels predicted for years to come indicate that saving will not go out of style for a while.

Is 4% enough? Let's assume you're part of a household having an annual income of $100,000 dollars, with a marginal federal income tax bracket of 28% and a marginal state income tax bracket of 6%, and pay $25,000 total in federal and state income taxes (this figure may vary, depending on your state, deductions and credits). Your disposable income would be $75,000. Let's further assume that you save 4% a year, or $3,000, with $2,500 going into a retirement account and $500 in a regular bank account. Assuming you work 40 years, with an average inflation rate of 3% per year and an average return of 6% per year on your savings (stocks have a higher historical average return, but you shouldn't put everything in stocks), you'll have about $445,000. Adjust that figure for inflation and you'll have about $131,500 current dollars.

Conventional financial planning wisdom dictates a person retiring at age 65 shouldn't spend more than about 4% of his or her retirement savings a year. With $131,500, that comes out to $5,260 a year (a figure that can be adjusted for inflation each year). We're still scanning grocery store flyers for dog food sales. But, of course, just about everyone gets some Social Security. A relatively high income married couple that averaged $100,000 a year for 40 years might get something like $40,000 a year in Social Security (assuming one member of the marriage earned the bulk of the income and the other takes spousal benefits). A person living alone with an earnings history averaging $100,000 a year might get around $28,000 a year. Add either figure to $5260, and there's a much better chance the dog food will stay on the store shelf.

Retired persons tend to have greater medical expenses, and savings can disappear in a flash when a medical crisis comes up. While $131,500 is nothing to sneer at, it won't cover two years in a nursing home. And you'll have plenty of out of pocket medical expenses before you have to move to the nursing home. So you can't count on the $131,500 to be there late in life. Most people in their 70s and 80s probably wish they had more savings.

The finiteness of your income means that saving is essential to retiring on more than Social Security. Every dollar spent now is a saving opportunity lost, one that can never be replaced. Saving isn't a sacrifice. You're buying a better retirement. If you want to maintain the lifestyle you have during your working years, save about 15% to 20% of your pretax income for 30 to 40 years (here's why such a strategy works: Such a savings rate can be difficult, but so is eating dog food (we assume; haven't personally tried it). You can economize now or economize later. There's still no free lunch. Rugged individualism, America's cultural essence, today consists of having a stable financial foundation. The frontier is still there, but you no longer carve a homestead out of the wilderness and fill it with amber waves of grain. Today, savings and investment accounts substitute for horse, plow, ax, scythe and long rifle.

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