Retirement Planning for Millennials

The USA Today ran a story about a recent college grad who is saving and investing aggressively with the hopes of early retirement. He’s 23 now and would like to retire by age 40. Here’s more on his lofty goal:

Frank’s goal is to save $900,000 by age 40. To make that happen, he wants to invest $25,000 per year, in today’s dollars. Along with that, he is working to increase his income to $90,000 per year. He acknowledges that he may have to stash away more money as he grows older, but hopes to front-load as much as possible to take advantage of compounding.

The secret to Frank’s saving success lies in automation. “I’m a fan of externalizing basically any system that you can,” he says. “I automate everything.”

I love to see a young person that understands the importance of compound interest. Ask a middle-aged person what they wish they would have done differently with their finances when they were younger and 9 times out of 10 they’ll say they would have started saving sooner. Millennials generally don’t care about retirement because it can be somewhat depressing to plan for old age when you’re so young and carefree.

The emphasis has to be on ‘why’ you are saving at that age. Frank’s ‘why’ is early retirement, which has helped kick-start his savings at an early age. And while I applaud Frank for building a solid system for saving and investing as much as possible right out of college, there are many other considerations he has to take into account when planning for early retirement.

At the standard 4% withdrawal rate Frank would have an annual income of $36,000 if he’s able to reach his $900,000 goal by age 40. But $900,000 in 17 years is not the same thing as $900,000 today. At a 2% annual inflation rate that $900,000 will only be worth close to $643,000 or just over $25,000 in annual spending. If inflation is 3% per year, it would only be worth $545,000 or just shy of $22,000 with a 4% withdrawal rate (and these numbers are before taxes are taken into account).

It’s possible for some to live on that level of income, but I’m not sure that’s what many consider when they think about the lap of luxury in early retirement. Frank will likely have to live off of his investments for a very long time as well. According to the Social Security life expectancy calculator, a 23-year-old male can can expect to live to 82 years old, on average. For a 23-year-old female the average life expectancy is 86.

This is a great problem to have, but it also means your finances have to last much longer. The 4% withdrawal rule is generally tested for 30 year time frames to assure people that their investments won’t run out on them. Longevity risk only increases the earlier you retire. Frank could have 40-60 more years remaining to live off of his savings if he stops working at age 40. That leaves little room for error.

I’m not trying to crush Frank’s dreams here. It’s possible that he could retire younger than most if he continues to save and develop his human capital by earning more money. It’s nice to have goals as a young person, but I would advise against selecting an exact dollar amount and age for retirement. There are just too many variables that have to be taken into consideration when planning ahead — taxes, your future income, financial market returns, spending rates, debt levels, lifestyle, etc.

This doesn’t mean young people should give up on thinking about retirement altogether. It just has to be framed differently when you have many decades to plan for. Retirement planning is a process that will always be under construction. Circumstances and priorities change over time as work, family, health and incomes are constantly evolving.

It’s impossible to perfectly plan for everything in advance since no one really knows exactly what their situation will look like in the coming decades. You almost have to work backwords by first figuring out the kind of lifestyle you’ll require and then making sure you’ll have enough capital to cover yourself and anyone else that depends on you (i.e., children are not cheap).

My advice to Frank would be to continue your automated saving system  attempting to increase your income. You are far ahead of the majority of your peers in that sense. Those are the two of the three pillars of building wealth (the third is staying out of debt). But every individual’s retirement planning system has to remain flexible as far as the end goals are concerned because life and the financial markets can always intervene.

So track your progress as time passes. Make adjustments when necessary. And try to find a career that you love. That way if early retirement needs to be put off for a few years at least you’ll be doing work you enjoy while you continue to build your savings.

Source:
How One Recent College Grad Intends to Retire at 40 (U.S. News)

Further Reading:
The 4 Year Rule
You Might Have a Really Long Time Horizon to Invest