Grab the Roadmap

John Lim

FINANCIAL SECURITY is within your reach. Don’t believe me? Here’s a roadmap that demonstrates it’s possible for most Americans.

Sam is a 22-year-old college graduate. He begins working right after college, earning $50,000 a year. He saves 20% of his income the first year, equal to $10,000. Each year, he gets a 2% raise. This raise is over and above inflation, which we’ll assume is zero to keep things simple. In addition to saving $10,000 a year, he takes half his annual raise and also socks that away.

For example, in his second year on the job, his salary increases from $50,000 to $51,000. He takes half the raise, or $500, and adds that to his annual savings of $10,000, so he saves $10,500. He continues in this manner year after year. Since he’s saving half of each year’s raise, his savings rate slowly increases, reaching 25% at age 32 and 30% at age 43. Sam also consistently invests his savings, getting a long-term average annual return of 6.2%. More on that number later.

Meanwhile, Sam’s standard of living isn’t stagnant. His annual spending rises from $40,000 right after college to $50,000 by age 40 to a little over $60,000 by age 53.

What’s happening to his nest egg? By age 49, Sam has become a millionaire. The year before he became a millionaire, Sam’s cost of living was $56,000. That means, if he retired at 49 and wanted to maintain his current standard of living, he would need to draw 5.6% from his nest egg.

Sam is a conservative guy and thinks 5.6% is too high. Maybe he could swap to a less stressful job with more time off, taking a 50% pay cut in the process. Since he made $82,000 the previous year, a 50% pay cut would mean an income of $41,000. Now, he only needs to draw $15,000 from his nest egg to maintain his $56,000 lifestyle, which would equate to a 1.5% withdrawal rate. That sounds a lot better.

While it sure feels good to know he has options, 49-year-old Sam isn’t quite ready to throw in the towel. He continues to work and save as he’s been doing. Nine years later, at age 58, his nest egg has grown to $2,108,000. Sam is now seriously contemplating a career change or maybe even outright retirement. Can he pull the trigger? You bet. If Sam were to withdraw 4% of his nest egg—based on the popular 4% rule—that would equate to an annual income of a little over $84,000. That’s $20,000 more than he spent the previous year. Not only can Sam retire, but also he could seriously upgrade his lifestyle.

Notice that it took Sam 27 years to become a millionaire, but only nine additional years to reach $2 million. Any guess on how many years it would take Sam to get to $3 million? Just five years. These numbers demonstrate the power of compound interest. Even if Sam stopped saving once he became a millionaire at age 49, his nest egg would still grow to $2 million. Instead of taking nine years, it would take 12 years—just three years longer.

Are my assumptions realistic? The first set of assumptions are largely outside of our control. I call these the financial assumptions:

  • Sam had a starting income of $50,000 a year. As it happens, the average starting salary for a bachelor’s degree graduate was just over $50,000 for the last three years, according to the National Association of Colleges and Employers. Median household income reported by the U.S. Census Bureau for 2016 was $59,039.
  • Sam’s income grew 2% each year. Median wage growth since 1983 has been 4% a year. Subtract 2% inflation and you get 2% real income growth.
  • Sam’s savings collected an average annual return of 6.2%. This number comes from assuming an 80% stock-20% bond portfolio and using real long-term rates of return of 7% for stocks and 3% for bonds. While we’ve enjoyed such performance historically, there’s a good chance returns will be lower going forward. But that doesn’t change our story much—because what drives Sam’s success, more than anything, is his savings habits.

The second set of assumptions are largely within our control.  They are what I call the personal assumptions:

  • Sam begins to save at age 22, which is the age many young adults graduate from four-year colleges.
  • Sam saves 20% of his income right off the bat.
  • Sam takes half of every annual raise and adds it to his yearly savings.

I can already hear the objections: “Save 20% or more of my income? Get real. Maybe you can do that if you’re making a six-figure income, but otherwise you’re out of your mind. I can barely make ends meet living on $50,000.”

Here’s my rebuttal: If $50,000 covers the bare necessities of life, how are those earning $40,000 surviving? Alternatively, what about those families earning $62,500? Surely they can live off 80% of their income—which would be $50,000—and save 20%? My point: Saving 20% of your income is never easy, because it means denying yourself things that you have the means to obtain right now.

But what’s the alternative? The savings rate has hovered around 6% recently. If we run the same scenario as before, but change the savings rate to 6% and the name to Frank, here’s what we find:

  • Frank reaches the $1 million mark at age 69 and $2 million at age 80.
  • If Frank retires at 69 and uses the 4% rule, he would have annual income of $41,000. Just before quitting the workforce, however, he had been spending $116,000 a year.

The bleak reality: A 6% savings rate means the financial milestones take many more years to reach. Frank waits two decades longer to become a millionaire. Even worse, the low savings rate equates to a higher spending rate, meaning Frank is faced with a difficult decision at age 69. He can retire and massively downgrade his standard of living—or he can keep working.

Will you be a Sam or a Frank? Just remember the truism that applies not just to personal finance, but to all walks of life: You can have it easier now and harder later—or harder now and easier later. What about easier now and easier later? Lots of folks behave like that’s a choice, but it isn’t.

John Lim is a physician who is working on a finance book geared toward children. His previous articles were Bearing Gifts and Lay Down the Law. Follow John on Twitter @JohnTLim.

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