Ever heard of "the rule of 72" with respect to your retirement? It is not your retirement age, at least not if you start saving and investing early on so you approach your retirement age with sufficient capital to enjoy a peaceful retirement.
The rule of 72 simply gives you a rough estimate how long it takes before your money doubles at a stated interest rate. When interest rates are 6% it takes you 72/6 = 12 years to double you money. If you receive 4% it takes you 18 years, 2% requires 36 years of waiting and at 1% it is unlikely that you can even double your savings ahead of retirement as it takes you a staggering 72 years to double your money. Please remember that these are approximations.
The great non-linearity of compounding interest, which is interest over interest, triggered Albert Einstein in calling it the "the most powerful force" in a lifetime.
Record low interest rates
The Federal Reserve Discount rate, the official rate set by the Federal Reserve Board, has been cut from 6.25% in 2007 to record lows around 0.25% at the moment. While this has resulted in large subsidies for the banking sector in order to improve the financial stability, it has been detrimental for savers and retirees. Many retirees have seen a drop in investment income as they tend to invest money in fixed income securities. Many retirees have postponed their retirement or found temporary jobs to provide them with meaningful income during their retirement period. At the moment 10 year government bonds are earning merely 1.6%. So what are your options to retire comfortably?
Save more, earn longer or earn more
In general people have started their work careers at the age of 20 for blue collar work and 25 for white collar work. Retirement ages vary between 60 for people doing hard manual labor and 65 which is the official retirement age. In recent years many people have been working until their seventies to fill up their shortage in retirement funds. It seems fair to say that most people tend to work for about 40 years over the last decades.
To give us a clue about how the average prospective retiree is doing, 401k plans give us a great deal of information. Remember that many employees do not even take part in these private-employer plans as they simply lack to see how important retirement is. Fidelity Investments and Vanguard are among the largest mutual fund managers looking after these 401k plans. By 2011 the average balance of a 401k with each of these firms came in at $75,000 and $78,000, respectively. Worrying is that median balances are much lower at $23,000 and $25,000 respectively.
So how long to you have to safe for?
According to data from the Center of Disease Control the average US life expectancy in 2010 is about 79 years. Note that you should not prepare to save for just 14 years if you plan to retire by age of 65. Given that you reached the age of 65 your conditional life expectancy has risen to an actual 83 years, suggesting that on average you should save for 18 years of retirement.
A Base Case
So let's assume you are 65 and you end up with an average 401K balance of about $75,000 which earns 2% given today's low interest rate environment and dismal returns on equities. How much can you withdraw on a monthly basis from age 65 onwards? Just a mere $413 according to the annuity calculator from bankrate.com
Remember that these rates are not adjusted for inflation and $413 at the time of retirement will not buy you the same as it does today. If this is not enough to live on besides your social security benefits you can do the following:
1. Double your contributions
Starting retirement with a higher balance, linearly increases your monthly payout. So a starting balance of $150,000 will get you $826 a month in payouts. If you work on average 40 years during your life you have time enough to increase your savings. And you should, because deductions into retirement funds are tax-free up to certain levels and often your employer will make matching contributions!
2. Obtain higher investment returns
During you working period (or your saving period) higher returns allow you to start with a higher initial balance. Even if you manage to increase your returns from 2% to 4% during retirement you could increase your $413 in monthly income to $486. Increasing returns to 6% allows you to withdraw $566 in monthly benefits.
Diversify your investments into a diversified portfolio of blue-chips paying out high dividend yields. Many top notch companies pay dividend yields far surpassing the yield on 10 year government bonds. Exxon Mobil (NYSE:XOM) pays 2.8% in annual dividend yield, General Electric (NYSE:GE) 3.5%, AT&T (NYSE:T) 5.1%, Johnson & Johnson (NYSE:JNJ) 3.9%, Procter & Gamble (NYSE:PG) 3.6%, Intel (NASDAQ:INTL) 3.2%, Philip Morris (NYSE:PM) 3.7% and Verizon Communications (NYSE:VZ) 4.7%. On top of the superior dividend yields, equities allow you even more upside in the form of capital gains.
3. Shorter your retirement period
Don't go the easy and dangerous route by lowering your expected life expectancy but postpone retirement by a year or two. Retiring at age 66 instead of 65 allows you to withdraw $433 instead of $413 per month. Retire another year later and you can withdraw $456 in monthly income.
4. Combine it all!
Save more during your working period, obtain higher investment returns and postpone retirement. Starting your retirement with $150,000 in capital, obtain investment returns of 6% and retire at age 67 allows you to obtain $1,211 in monthly income, almost three times as much as our basecase scenario.
It is important to familiarize yourself, how boring or far away the topic might be. Recognizing issues early on allows you to make adjustments so you can comfortably retire. Remember that you have options, just make sure you recognize them in time and you have the discipline to save enough to enjoy a well-earned retirement.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.