There was a great discussion last week on Reddit’s Personal Finance subreddit  about how people find the balance between saving for the future versus spending today. The original poster was curious how to draw the line between putting money aside for some nebulous future need versus something that is very tangible and enjoyable today. Then he adds in the kicker, which I think is a fear for a lot of folks, of what happens if those savings are eroded because your savings vehicle (i.e. stock market) crashes or does poorly?
There are really two questions in there and I’ll explain my approach to both.
Future vs. Now
A lot of folks like to think of this in terms of their “Number.” The Number is how much you need at retirement in order to live the lifestyle you want. For this, I think the exact number isn’t important, it’s coming up with the number and having that as your target goal.
Calculating your number is simple:
- Calculate your expenses today, add a buffer for what you think you’ll want in terms of extra to “enjoy” retirement (really, your non-working non-income generating years).
- Use the 4% rule  to calculate how large of a nest egg you’ll need, based on your annual expenses.
- Calculate your Number using 3-4% for inflation.
If you estimate that you need $50,000 a year to live comfortably in retirement, then you know you need a nest egg of at least $1,250,000. If you don’t retire for 40 years and you assume inflation is 3%, your target number is ~$4,077,547.
How much do you need to save? That will depend on how much you have saved now, your annual interest rate, and how often it compounds. If we assume you start with just $1, a growth rate of 9% that compounds annually, then you need to save $965 per month for 40 years to reach your goal of a $4 million nest egg.
$965 per month is a lot. But there are more factors that the few we’ve listed. You will likely have some sort of Social Security payments or pension, which would reduce the number you need. You may opt to save more while you’re younger, before marriage and before children (i.e. expenses!), or you may find that you don’t need $50,000 a year in retirement.
The goal, however, isn’t to find the exact number – it’s to find a number so you turn the nebulous “save for the future” into something tangible like the current need.
Savings Growth vs. Loss
This one is a little harder to wrap your head around because you can never predict the future. I simply rely on the fact that the stock market goes up in the long run and it goes up in a predictable pattern… in the long run. As you near retirement, it’s important that you start shifting into less risky assets because that’s what you’ll be using in the short term.
Let’s say you’re twenty years old, all of your retirement assets should be in stocks. You won’t need that cash for forty years. As you get older, some of that money gets closer and closer to being used. When you hit sixty, the money you plan to start using in the first few years of retirement should be in something ultra-safe.
It’s no different than when you’re saving for a house. If you’re saving for a house, those funds should not be in the stock market. Your near-term retirement funds should be in something that won’t give you great returns but comes with little risk of loss.
Everything about the future is based on faith anyway, the savings growth vs. loss issue is no different. If you have a long enough time horizon, the stock market will always come back. Check out the S&P 500 chart for the last 10 years:
In March 2009, at the depths of the Great Recession, it fell as low as 683.38 after being as high as 1561.80 in Oct 2007. And in May 2013, it hit 1667.47. From peak to peak, even after falling to less than half of its value, it was less than six years. (of course, you can find just as many tech stocks that have never recovered from the dot com boom but the broader market seems to always bounce back)
Compare Tangible Numbers
Finally, how do you decide on future versus today? It’s simple once you have a number for the future and a target savings goal. If you want to buy that widget or go on that vacation, your decision is whether you save more towards your number and forgo the trip… or save less and go on that trip. By having a tangible comparison, you can make an informed decision.
How do you make these decisions?
(Credit: Alan Cleaver )