For this week’s article, I was going to write about how, when saving for retirement, the amount you put in over time is more important than the returns you get. Then I read a blog by Tim Fallaw of DataPoints on the exact same subject. Tim has very kindly given permission for me to share his article, which is below.
We have talked here before about the difference in savings rates between “high-potential” individuals and “low-potential” individuals, as measured by scores on the DataPoints Building Wealth assessment. As a quick refresher, Building Wealth measures behaviors and attitudes in six key behavioral areas that have been shown to have a strong positive correlation to building wealth over the long-term. In fact, as you may know, many of these characteristics were first identified in the research that was the foundation for The Millionaire Next Door back in 1996. Individuals scoring high on the assessment (and thus referred to as “high-potential” individuals) saved on average 17% of their disposable income every month and year, as compared to only 7% for their low-potential peers. (And note that 7% is higher than the current national average savings rate.) That’s an additional 143% in savings every month and year for the high-potential individuals.
You may be thinking: Ok, fine. So 17% is, mathematically speaking, 143% more than 7%. Lies, damn lies, and statistics. It’s really only 10% more of your salary every month. I get that it is nearly 2.5 times the savings of the low-po individuals, but does it really make that big of a difference when you’re talking about real-life savings figures? And by that I mean real-life dollars? And surely it must be the case that the real wealth differentiator over the long-term is investment returns, not something so simple and dull as savings rates, right?
Fair question. Let’s answer it by looking at a hypothetical situation and running some numbers. Here’s the hypo: we have two product managers, Rita and Alison, fresh out of school and having spent a year or two paying off any student debt. They are now ready to begin saving at the early age of 25. They both earn $60,000/year in salary. They both receive annual raises to the tune of 4%. Both invest their savings in identical low-cost index ETFs earning a total annualized market return of 6%. They are identical in every respect except one: Rita manages to save 17% of her gross annual salary, whereas Alison saves only 7%.
So what happens over a 30-year working career? Here’s a chart showing their respective net worth over the ensuing three decades:
At age 40, Rita has amassed roughly $340,000 in net worth compared to Alison’s $140,000. And this dollar disparity only magnifies over time. By the age of 50, Rita is almost to millionaire status at $905,000 compared to Alison’s $373,000. And by the time they get to the end of their 54th year, Rita has banked a whopping $1.275 million compared to Alison’s $525,000.
Here at DataPoints we’re not financial planners, but that sure smells like the difference between retiring at the beach and, well, not retiring.
Changing behaviors—especially spending and saving behaviors—can be hard. So hard, in fact, that it can be tempting for financial advisors and their clients alike to put their faith and hope instead in oversize investment returns. The thinking goes: “well, I’ll just have to do better on the investing side in order to make up for poor savings behaviors.”
Let’s consider this variable by changing the hypothetical. Let’s assume now that instead of receiving the paltry market-average annualized returns of 6%, Alison is able to find an advisor that beats the market every single year by 2.5%. We’ll keep all of the other variables the same, except now Rita earns 6% in investment returns every year as compared to Alison’s market-beating 8.5% every single year.
Here’s what the future looks like now:
The additional 2.5% investment alpha every single year for 30 years closes the gap for Alison, but not nearly as much as we might have expected. Now at the end of that long period of time, Alison has amassed $776,000 as compared to Rita’s $1.275 million. Still a very significant and meaningful delta to be sure.
And keep this in mind: while Rita’s result based on 6% annualized total returns and a 17% savings rate is completely plausible and largely within her control, the 2.5% investment alpha scenario (over a 30-year period) is, if we’re being realistic, largely if not completely impossible.
Using future-value calculations to put dollar figures on these various savings rates over a 30-year working career vividly and dramatically paints the picture of the disparate financial results to be achieved through a change to this critical variable. In our experience, it is easy for both professional financial advisors and their clients to be focused on the more sexy data point of investment returns. But in reality the savings-rate variable has a much greater impact on long-term financial success. And as an additional plus, it also happens to be wholly within your control.
DataPoints is a key part of our financial planning process in helping clients achieve financial independence. It helps us highlight clients strong points in saving money and where they need help.
If you have any questions, drop me an email at firstname.lastname@example.org