## Empower young investors with savings plans.

May 29, 2016

The purpose of this article is to help young people make long range savings plans.  It’s a three-step process: 1) Set the goal. 2) Adjust for inflation. 3) Make recurring payments. I begin by presenting a retirement savings plan and conclude with a generic process for making other savings plans.

### Planning for retirement

QUESTION: How much money should I save to start retirement?

ANALYSIS: I know people save money for future expenses even though inflation increases those expenses. Thank goodness my current budget is designed to pay for emergencies and pay all debt before retirement. If I live within my means and save 25 times my annual salary, I could safely withdraw 4% of those savings in the first year of retirement and keep withdrawing that amount, adjusted for inflation, each year of retirement. Life would be good! [refs 1-3]

GOAL: Save \$25 per dollar of annual salary, plus an adjustment for inflation. The goal has 2 parts: 1) The savings account should hold at least \$25 for every \$1 of gross annual salary. 2) Every saved dollar should be inflated to match the Economy’s inflation rate.

STRATEGY: Start to invest regularly at the beginning of my career.

1. Starting at approximately age 25 and finishing at approximately age 75 will provide 50 years of opportunity to save for retirement.
2. At an annual inflation rate of 3%, the average price of everything that costs \$1 today will likely be \$4.38 fifty years from now (check this estimate with a future value calculator).
3. My real savings goal is \$25 X \$4.38, which rounds to \$110 for per dollar of salary.  The planning table in Fig. 1 will help me select a regular deposit.

Fig. 1

For instance, a stock index fund that’s expected to earn a 10% annual rate of return could accumulate \$110 when 9 cents per year are deposited into the account for 50 years.

How does this apply to me?  Suppose I start earning \$50,000 a year at age 23 and invest in a stock index fund that earns an 8% rate of return. Thanks to the help from my parents, I already have \$1,000 to open an investment account. According to the 50-year plan in Fig. 1, I will choose to deposit 18 cents per year for every dollar of salary. That means my annual deposits will be \$9,000 from the \$50,000 salary. If things go right, my investment account will be worth \$5,546,902 after 50 years. Really?!!?

• The future value of \$1,000 is \$46,902 based on an annual return of 8% for 50 years {test this calculation with the future value calculator}.
• The planning table in fig. 1 is designed to earn \$110 by making regular deposits for every \$1 of salary; \$110 X \$50,000 = \$5,500,000.
• \$46,902+\$5,500,00 = \$5,546,902.  Happy retirement!

THEN WHAT? Plan on safely withdrawing 4% of your savings at the beginning of retirement in order to match your annual salary before retirement; 4% of \$110 is \$4.40. Next year withdraw the same amount plus extra cash to adjust for inflation. The adjustment factor is (1+I) for the annual rate of inflation. Assuming that I is a 3% rate of inflation, (1+0.03) X \$4.40 = \$4.53. Each succeeding year, withdraw the same amount as the previous year plus an adjustment for inflation. In the first 5 years of retirement your annual withdrawals will be \$4.40, \$4.53, \$4.67, \$4.81, and \$4.95 per \$1 of pre-retirement salary and you will have plenty of savings for the rest or retirement [refs 1,2].

### Risk management

There’s no guarantee that your plan will work. What could go wrong and how do you avoid failure? Some likely risks are missed deposits, taxes, low rates of return, brief time, and market declines.

1. Missed deposits- Deposits energize the process of compounding interest to accumulate savings [ref 4]. Avoid missing deposits by making automatic payments through an employer sponsored savings plan –e.g., 401(k), 403(b)– or through payroll deposits into an individual retirement account (IRA).
2. Taxes- Tax-deferred savings plans reduce your taxes. Deposits into employer-sponsored retirement-savings plans and traditional IRAs are not taxed until withdrawals are made after retirement when the withdrawals are taxed as regular income. Deposits into a Roth IRA are taxed at the time of deposit, but never taxed again. If the traditional and Roth IRAs are not affordable for you, the U.S. Government offers an affordable Roth IRA called the MyRA. If you wish to invest in Treasuries and corporate bonds, beware that they ares taxed at a higher rate than the long term capital gains from stocks.  Use a tax-deferred account to invest in bonds [ref 5].
3. Low rates of return- Stocks reputedly pay higher rates of return than bonds. Investing in individual stocks is a risky and time-consuming effort; joining an investment club may be helpful. Consider buying shares of index funds that invest in market sectors with the understanding that investing in market sectors is riskier than investing in broad markets.
4. Brief time- Start investing while you’re young. Starting later will require larger payments.
5. Market declines- Since 1929 the average stock market cycle was 40 months divided into 30 months of price inclines and 10 months of price declines [ref 6]. The net effect was an uptrend in prices over long time periods. Individual investors can protect their investment returns from market declines in two ways: 1) Continue investing during market declines when regular deposits will purchase more securities at lower prices. 2) Diversify by adding bonds to your stock portfolio. This is best done by making supplemental payments for bonds in tax-deferred accounts such as MyRA.

### Generic savings plan

Any long range savings plan can be made in 3 steps:

1. Set a goal for how much money you want to save. Your goal becomes the accumulated amount calculated by the compounded interest calculator [Fig. 2].

2. Adjust for inflation by multiplying your goal by the factor (1+I). I is the decimal value of the annual inflation rate. If you choose last century’s average annual inflation rate of 3.2% [ref. 7], the factor is (1+0.032). If 3.2% seems too high, use your internet search engine to discover more recent inflation rates.

3. Determine recurring payments needed per \$1 of annual salary.  Display them in a customized planning table similar to Fig. 1.  Here’s how:

• The columns are values of N for the number of years. Choose at least 2 time periods for the sake of versatility.
• The rows are values of R for an investment’s annual rate of return. Choose a practical range of stock and bond returns for the sake of versatility.
• The cells display fractions of \$1 for making the minimal recurring deposit (d). Determine the deposits by testing trial values of d in the compounded interest calculator (Fig. 2). For example, start with d = 10 cents at the highest rate of return (R) for the longest time period (N). 10 cents represents the idea of depositing 10% of every dollar in your annual salary [Hint: it’s practically impossible to deposit more than 50 cents per dollar of salary].
• In Fig. 2, the value of PV can be \$0 unless you already have an initial deposit.

### Appendix: All-purpose Savings Calculator

Try fig. 2’s all-purpose savings calculator that’s in the open-source publication of PracticalMoneySkills.com [ref. 8].

Fig. 2

Note: Fig. 2 can be validated by tests using the compound interest formula for annual additions discussed in ref 4.

### References

1. Jane Bryant Quinn. How to make your money last. The Indispensable Retirement Guide. 2106, Simon & Shuster, New York. 366 pages.

2. William P. Bengen. Determining withdrawal rates using historical data. Journal of Financial Planning, pages 171-180, October, 1994.

3. Craig L. Israelsen. The importance of diversification in retirement portfolios. AAII Journal, April, 2015. pages 7-10. American Association of Independent Investors.

4. Miranda Marquit. How does compound interest work for investments? ©️2016 empowering media inc. 2/18/2016.

5. Types of Retirement Plans. IRS.gov, 10/7/2015.

6. Paul A. Merriman. 22 things you should know about bear markets. Aug 24, 2015. MarketWatch.Inc, ©️2016.

7. Tim McMahon. Average annual inflation rates by decade. June 18, 2015.

8. Compound interest calculator. PracticalMoneySkills.com. ©️2010 Visa.