Managing Your Clients’ Retirement Metrics

Respect the power of compounding. But that’s not the whole story.

By Guy Baker

Key Takeaways:

  • The earlier clients start saving for retirement, the more likely they are to reach their NUMBER, but that’s not the whole story.
  • Savers in their working years need to know their NUMBER, as well as how much they need to save each year and the investment process that’s going to get them to their NUMBER.
  • Lifestyle and inflation are important variables in helping clients ascertain their retirement NUMBER.

The power of compound interest works inversely with age. The younger you are, the more powerful compound interest is and the more it works in your favor. But the young often fail to get the message soon enough. As a result, by the time they wake up to the realities of retirement, they have lost 50 percent or more of the compounding power of money. Look at this chart below.

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This chart calculates how much of your retirement will be contributed by the POWER of compounded growth, assuming you can earn 7%. In each case, the goal is $1,000,000.

Assume your client is 30 years old. You can see that 79.96 percent of the $1 million comes from compounding growth while only 20.04 percent would need to come from contributions. Now, compare that with age 50: Compound interest contributes only 51.21 percent to your client’s wealth, while 48.79 percent of the $1 million must come from their contributions. As your client gets older, there is less time for compound interest to build wealth.

There are three key elements everyone needs to understand and manage to make certain they are going to retire with an income that is close to their goal.

  1. The first thing you need to know is your target savings NUMBER at retirement.
  2. Once you know your target, you need to calculate how much you are going to have to save annually to reach your NUMBER.

Have an investment process based on an intellectual framework for making investment decisions. Around this framework, you need to exercise emotional control over anxiety and fear when the markets get rough. This is hard to do when everyone is yelling “Sell—the sky is falling!” Studies have shown that people are twice as inclined to avoid loss than to pursue gain. Yet selling is exactly the wrong reaction. Your client’s NUMBER is a function of his or her target income at retirement. There are two aspects to this calculation—lifestyle and inflation. Economists say people will need between 70 percent and 100 percent of their pre-retirement income to live comfortably in retirement. Most studies say you probably need more than 70 percent. This is a floor for consideration. So if a client is earning $75,000 per year just prior to retirement, then he or she would need income at retirement of between $53,500 and $75,000 per year. But that is NOT the end of the story.

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The charts at left show the annual inflation rate going back to 1914. What exactly is inflation? Inflation measures how fast goods and services increase in cost on an annual basis. When I was first starting to drive a car, the cost of gasoline was just 10 cents per gallon. Compare that with $3.50 per gallon today. This increase in price is referred to as inflation. The price reflects the cost of drilling for oil, shipping the oil to the refinery and the cost of converting the oil to gasoline. Built into this price are wages, the increased cost of drilling for oil and, of course, taxes. A healthy economy grows, in part, because of inflation. If inflation is too high, then incomes and the value of commodities can’t keep up and people get hurt financially because of it.

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Seniors are especially susceptible to the ravages of inflation because they are on a fixed income and rising prices take more and more of their net spendable income away. A fixed income does not go up as the price level increases. The chart to the left shows the average annual inflation rate by decades. It shows how inflation has changed over long periods of time. As of now, the average rate since 1925 is about 3 percent. This means the cost of goods and services will double about every 25 years.

So if your client is 25 today and is earning $75,000, by age 50 he or she will need to be earning $150,000 just to buy the same amount of goods and services as today. If your client lives to 75, he or she will need $300,000 to be in the same place. Obviously, this puts a lot of pressure on one’s income and the need to build enough capital at retirement. So how do these two factors work when trying to calculate your client’s ideal NUMBER?

The amount of capital you need when you retire is tied to both factors above. It starts, of course, with one’s income goal. But assuming we can establish a goal at retirement, we need to factor in inflation to preserve a client’s purchasing power. If a client is 20 today, the target is $75,000 in today’s dollars, and he or she will need to accumulate $6,575,859 by age 70 to have a guaranteed income for life. Look at the “Your Number at Age 70” chart below to see how much you need at various assumed growth rates. Notice, if your client could earn 7 percent during retirement, he or she would need a lot less to achieve the same goal: $2,950,290. The question is, can clients sustain this return and afford the downside risk? This is called sequence risk—the risk of receiving low or negative returns early in a period when withdrawals are made from underlying investments—and will be discussed in another article.

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If we combine the concept of compounding power and how to calculate your NUMBER, look at the pattern that emerges. If clients wait to fund retirement until they are older, it becomes a hill that is very difficult to climb. This “Funding Your NUMBER” chart displays how much clients have to contribute to retirement accounts to reach their goal.

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If they are 30, at 7 percent, they will need to save $14,778 a year to reach their $2,950,290 goal. But this assumes they will earn 7 percent throughout retirement. If they decide to be more conservative and target 4 percent during retirement, they need to have $3,586,439 to make $244,653 of income last for life. How much do they have to contribute at 7 percent to reach $3,586,439? They need to contribute $17,965.

At age 30, at 7 percent, the total available at age 70 would be $2,950,290. The contributions would be $591,136 ($14,778 per year for 40 years). The compound earnings would be $2,359,153. At 30, the contributions represent 20 percent of the end value and the earnings represent 80 percent for results. If they wait until age 50, they need less capital because the inflation effect will be less, but their contributions are significantly higher in order to sustain the same purchasing power. If they start at 50, they need to contribute $44,672 if they can earn 7 percent on their money. The chart below calculates the ratio (compound earnings compared to contributions). For age 50 at 7 percent, the ratio is 51 percent earnings and 49 percent contributions; at age 60, compounding provides only 28 percent.

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What is the bottom line? You need to have a plan, you need know how much to save and you need a framework for investing that is insulated from emotional reactions.

About the Author

Guy Baker, MBA, MSFS, CFP® is a financial advisor to business owners. He works to help owners find ways to reorganize their planning to achieve tax-efficient solutions to their succession, retirement and estate planning problems. Guy is a 34-year member of Top of the Table and recognized by Worth magazine as one of the top 250 financial advisors. For more information, you can contact him at guy@bmiconsulting.com or through www.bmiconsulting.com.