How should young people prepare for retirement? It’s a great question considering the financial challenges to Social Security and the demise of pensions. For many young people, it can be difficult to make retirement planning a priority—after all, retiring is something you do when you’re old!
I believe that financial independence is a better goal—and the younger you start, the better. Young people should work to reach the point where they no longer rely on their employer’s pay, so that working becomes an option. Of course, many of us would choose to work even if we didn’t need to because we like our jobs. Experts tell us one of the keys to healthy living is having a purpose in life, and many people find their purpose through work.
This newsletter is the first of three dedicated to laying out the eight principles for reaching financial independence. Memorize them and share them with family and friends. Many people go through life stumbling around financially, hoping one day to win the lottery. Financial independence does not come by luck. It is within reach for many by learning and applying these principles to their daily life.
Principle 1: Always live below your means.
Many financial advisers say, “Pay yourself first,” which places a priority on savings. The importance of this principle is more profound than just accumulating savings—it’s about controlling your spending. It is impossible to become financially independent until your spending is under control. The US Government took in $3.464 trillion of income in the fiscal year 2019 but spent $4.448 trillion. Some could say the government doesn’t have an income problem; they have a spending problem.
Savings include contributions to an employer-sponsored plan like a 401(k). However, close attention should also be given to after-tax savings. It’s important to build a cash reserve for emergencies and continue to fund traditional IRAs or Roth IRAs. One method to accomplish this is to invest regularly into mutual funds through automatic deductions from a bank account. Some employers offer payroll deductions to make after-tax investing even more effortless. Automatic investment plans are an efficient way to stick with an investing program because money is invested before becoming available to spend on anything else.
Principle 2: Time is your most important ally.
Start early and save regularly. George Clason’s classic book The Richest Man in Babylon suggests we set out to accumulate savings that will work tirelessly for us. Most everyone starts life working to earn money. Saving early and regularly preserves some of those earnings, allowing them to grow to the point that they support you. Saving early allows time for money to accumulate. The potential gains on investments—and the annual compounding of those earnings—can make a big difference in the timing of financial independence.
A person who starts saving $275 per month at age 20 will have $1 million at age 65, assuming their savings grow at an average rate of 7% annually. If they wait until age 30 to start saving, it will take $575 per month to have $1 million at age 65, assuming the same return rate. Procrastinating until age 40 will require a monthly savings of $1,250. This illustrates how important time is to the success of a financial strategy.1
Principle 3: Social Security is a safety net, not a retirement plan.
Social Security will most likely be around for future generations. However, it will need to change from the system we know today to remain solvent. When Social Security became law in 1935, the average life expectancy was only 61.8 years. Half of working Americans were never expected to live long enough to collect their benefits. Today, life expectancy is approaching age 80. A healthy 65-year-old couple has a 25% chance that one of them will live to age 95.2 Social Security doesn’t have the resources to cover this longevity. Retirement age could be raised, benefits could be reduced, and the ability to collect benefits could even be means-tested, similar to how Medicare premiums are currently determined.
Politicians will need to work out the solution, and that may take some time. Those seeking financial independence should aim to do so without the aid of Social Security.
- Never spend everything you make. Your budget should be based on a maximum of 90% of take-home pay.
- Time is the most important word in our investment vocabulary. If financial independence is the goal, starting today beats waiting until tomorrow.
- Do not count on Social Security for financial independence.
- Nerdwallet.com Compound Interest Calculator
- How Long Can Retirees Expect to Live Once They Hit 65? By Wade Pfau, Forbes
Originally posted August 2012