The basic logic of saving for retirement is pretty straightforward: The more you sock away, the more you'll wind up with (all else being equal). But there are two other benefits to aggressive saving that many people overlook:
1. The more you save, the less you have to spend.
2. The less you spend, the less you'll need to have in your nest egg to maintain the lifestyle you've become accustomed to leading.
How It Works
Every dollar you invest with a long-term time horizon becomes a dollar you aren't spending today. And if you don't get around to spending that cash during your working years, it never creeps into your lifestyle.
The upshot is that when it does come time to retire, to maintain a consistent standard of living, you'll really only have to replace the income you'd been spending, rather than your total salary.
The table below shows a few examples of the "lifestyle equivalent" salary, based on different base salaries and savings rates:
% of Salary Invested
Source: Author calculations
Of course, if you haven't been aggressively investing, it's really hard to go from saving 0% to 30% of your salary without feeling the pinch. But if you're living fine on a $40,000 salary now, why not invest as much of your raises as you can? If you get a series of raises that takes you from $40,000 to $60,000, you could maintain the same lifestyle you have now, while eventually investing more than 30% of your income.
Here's another benefit of saving your raises instead of spending them: In these uncertain economic times, it's nice to know that if needed, you could take a lower-paying job and still be OK.
The Retirement Benefit
Once you are aggressively investing, you get both sets of benefits -- the faster compounding that comes from having more in your nest egg and the lower portion of your salary needed for your lifestyle. At that point, it's largely a matter of what rate of return you get and how long you keep at it that'll determine when you hit the point where your investments should be able to cover your costs of living.
The table below shows how many years you'll have to keep investing in order to reach the point where your investments would be expected to be able to cover your noninvested salary:
% of Salary Invested
Source: Author calculations, based on monthly compounding and the 4% rule for withdrawals
How much you stash away matters at least as much as the returns you get. Notice how putting away 30% of your salary at 4% annual returns gets you from $0 to retired in a bit less time than putting away 10% of your salary at 10% annual returns. That's good to know if the daily volatility in the stock market keeps you away from holding an equity-heavy portfolio.
You'll Still Need Stocks
Even if you are spooked by the stock market's volatility, you'll need to invest in stocks to have a decent chance of reaching the higher end of that return spectrum. As of today, long-term Treasury bonds yielded a scant 3.3%, and shorter-term debt had even lower yields. Even long-term investment grade (rated BBB or better) corporate debt isn't sporting double-digit yields.
Among the BBB-rated debts, the highest yield to maturity I found earlier this week was Genworth's (GNW) June 2020 offering, with a yield to maturity of 8.967%. And due in large part to the company's exposure to the mortgage insurance business, its debt rating is at risk of being downgraded into junk bond status. So that nearly 9% potential return is in no way risk free.
Over the long run, the stock market has been able to provide average returns around 10% annually. Yes, some years will be higher, and others lower. But when you're dealing with a time frame measured in decades, average returns become much more meaningful than the daily or even yearly fluctuations. And these days, it's easy to buy "the market" -- or at least individual securities that closely track the major indexes, like these do:
Investable Tracking Security
Dow Jones Industrial Average (^DJI)
SPDR Dow Jones Industrial Average ETF (DIA)
S&P 500 (^GSPC)
S&P Depository Receipts (SPY)
Nasdaq Composite (^IXIC)
Fidelity Nasdaq Composite Index (ONEQ)
Source: ETF provider websites.
Ultimately, however, no matter what rate of return you actually earn, the act of living on less than you earn and investing the rest will serve you well. The money you're able to sock away will give you a better retirement than you would have had without saving, and the more cost-efficient lifestyle you'll be living will help you maintain your financial peace of mind along the way.
At the time of publication, Motley Fool contributor Chuck Saletta did not own shares of any company mentioned in this article.
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