Awhile back, I post on The Richest Man in Babylon, The Power of Compounding where I quoted from the book The Richest Man in Babylon and highlighted the power of compounding.
Next, I received a comment from a reader and posted it in Comments: The Richest Man in Babylon, The Power of Compounding. The reader wondered how much was enough for the power of compounding to really make a difference. I asked readers to make suggestions on this questions and here's what the first had to say:
To me the "magic" point is when you're consistently making more in interest or other earnings each year than you're making in contributions. That's when you really go "whoa, money for nothing!" At 8% APY that happens around the end of your ninth year, assuming you keep the contribution constant. That's why a guy who saves $500 a month starting at age 20 and STOPS at age 30 will end up with more than a guy who starts saving the same amount at 30 and continues for the rest of his life. By the time the 20-year-old hits 30, his savings is making his $500 monthly investment for him.
Good thought. Here's another one:
There are lots of important milestones for me in saving for retirement. However, unlike a lot of people I base them on exactly this sort of question rather than when I have saved round numbers. For example, I recently hit an important milestone: my retirement savings will compound on its own to an amount that will be sufficient to sustain my income at an the inflation-adjusted equivalent of what it is today, without any further contributions from me. That means that everything I save from now on toward retirement serves one of two purposes. The first is that it will increase my income after retirement. Since I still expect my pre-retirement income to increase, some of that will be necessary to maintain my lifestyle at the level I'll be enjoying just before I retire. Second, I can bring my retirement date closer.
That second point is the whole reason for paying attention to this particular milestone. I've based my retirement date on when I can start drawing from retirement accounts at 59 1/2 years old. If I want to have money to live off of if I retire at 57, I'd better have it in other accounts that I can tap earlier. Yes, I've reached the point where I need to carefully consider how much I'm putting into retirement accounts vs. non-retirement accounts.
Wow! This person has done a great job of saving. To be in a position where the investment income will take care of the rest of the money needed for retirement is fantastic. Can't wait until I get there! ;-)
Finally, here's a more quantitative take on the question:
The magic number is pretty simple. Take your savings and multiply by .04 (4%), if you can live on that amount of money, go ahead and retire. Theoretically you should never run out of money. Of course expenses can rise dramatically (think taxes, health care and energy) which may make this theory obsolete.
I don't think this guarantees you of not running out of money, but gives you something like a 95% chance of having the money you need through age 90 or so -- which should be plenty.
For more thoughts on saving for retirement, see these links:
"The magic number is pretty simple. Take your savings and multiply by .04 (4%), if you can live on that amount of money, go ahead and retire."
I am 31 and I think I can retire easily, but in a "foreign" country!
Posted by: Futuralogic | April 28, 2006 at 09:53 PM
Speaking as your anonymous reader, I will point out that my savings came at a price and the job isn't done yet. I have an emergency cushion, but I wish it was bigger. I have some money saved for my kids' college education, but I haven't reached the finish line on that either. And to reach my retirement nest egg goal will require three things. One, the money will need to compound from now until I'm 59 1/2. Two, I'll need a return of about 7% after inflation. Three, I'll need for nothing to go so horribly wrong that I have to tap that savings.
I couldn't have gotten to this point without my wife. I'm frugal, but she has the discipline to actually do the financial work. She has evaluated all of the mutual funds in every 401(k) all along. She's filled out the paperwork. She's done any number of awful tasks for which I can't thank her enough.
Posted by: Anonymous | April 28, 2006 at 11:04 PM