Thoughts on personal finance (with spreadsheets!)

I am going to attempt to write about something different here on the blog.

I was having a conversation last week with my parents, and we were talking about personal finance, and I’m no expert on the subject, but I was a finance major, and I have picked up a few things over the years.

Anyway, during the conversation I said two remarks that they didn’t seem to believe, or certainly didn’t sound right without any support.

The money you save from age 22 through 30 will be worth the same as the money you save from age 30 through 60.

Holding off social security benefits until you are 67 will give you an extra $100,000.

Well, I have an obligation to back up these statements.

Let’s tackle the retirement issue first. The reason why saving in your twenties is so important is because of compound interest, a magical quirk of math that is the foundation of passive investing. In the finance world, we call this the time value of money.

Let’s say you save $10,000 a year for retirement for 40 years. Let’s assume you can grow your money at 7% per year, which is about what you can expect for your returns if you’re in the stock market.*

*Over the last 40 years, the S&P 500 has actually gained 8.3% annually, plus dividends. On July 9, 1974, the S&P stood at 81.48. It currently stands at 1972.83. For the purposes of this exercise, we’ll keep the rate at a conservative 7%.

Returns are certainly volatile year-to-year, but time is on your side. The market has been remarkably efficient.

OK, so, after 40 years you’ll have put $400,000 towards retirement. Well done. For your efforts, you will end up with a cool $2,136,096. Here is a model I built that shows the underlying calculations.

If you had saved for 30 years instead of 40, you end up with $1,010,730, which is still a nice number, but it’s less than half of the $2.1 million.

So, yeah, the money you save in your twenties is worth about the same as the money you save for the rest of your life. Every dollar you save now is worth $7.60 in 30 years, but jumps to $15 in 40 years.

This assumes that you’re investing in a wide range of mutual funds and aren’t putting everything you’ve got into, I don’t know, a tech company in the late 90s.

Of course, this calculation is leaving out a major factor: inflation. Lately, inflation has been hovering around 2%. Historically, it’s been a little higher, reaching as high as 14% in the late 70s and early 80s. If we assume 2% annual inflation for the next 40 years, then your REAL annual return is about 5%.

How does that affect your retirement savings in real dollars? After 40 years, you’ll have $1,268,398 in today’s dollars, which is still about twice as much as you would have had after 30 years. Here is a model I built that factors for inflation.

Now let’s tackle the Social Security issue. Right now, eligible retirees are able to collect Social Security at age 62. However, you have the option of deferring payments until you are 67, which results in a higher monthly payout.

The numbers vary person to person, but I did some research and ballparked the monthly payouts like this:

Retire at age 62: $1,300/month
Retire at age 67: $1,860/month

According to different sources I looked at, Social Security benefits are 30% lower at 62 than at 67, so these numbers are consistent.

Most will opt for the earlier payouts. And, that’s totally understandable, given the financial situation of many retirees. An extra five years of income goes a long way.

But, if you can get through those five years, you’ll be thankful. You break even when you’re 78. If you think you can make it to 80, it is worth holding off.

When you’re 85, you’ll have an extra $50,000.

When you’re 90, you’ll have an extra $83,000.

If you can make it to 100 – and, hey, don’t discount the possibility – you will have an extra $150,000. See here for the calculations.

I wish there was more of an emphasis on personal finance in high school and college. There was hardly any mention of it. So when you graduate college, you’re pretty much on your own in this strange world of taxes and 401k’s and IRA’s and the stock market. Thankfully there are some wonderful websites out there that walk you through the basics of handling a budget, saving for retirement, and investing wisely. I like Betterment.

Unfortunately, none of this is taught. It falls on us to take the initiative.

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