Recent research from Prudential Investments says that if millennials hope to retire at age 67 with a nest egg upwards of $1 million—which an earlier study indicates as a goal—they need to get an early start on saving and invest mostly in stocks. But young investors must also do one more thing that many investment firms fail to mention: keep investing fees to a minimum.
Almost every day it seems that a study or survey from one financial services company or another weighs in on how well or how poorly millennials are preparing for retirement, and then suggests how people in their 20s and 30s can improve their prospects. Some of the recommendations are wildly off base, but in many cases the advice can be quite sound.
Take Prudential's suggestions, starting with the one that millennials get an early start on saving. That isn't exactly ground-breaking advice, but it bears repeating if only because many people still may not fully appreciate just how much more difficult building an adequate nest egg can be if you put off saving even for a short time.
For example, a 25-year-old who earns $40,000 a year and gets 2% annual raises can accumulate a $1 million retirement account by age 67 if he saves 11% of salary each year and earns 6% a year on his savings. But if that 25-year-old doesn't get started until he reaches 30, he'll have to save 13.5% of salary each year to hit the seven-figure mark. And if he waits until he's 35, his annual savings target jumps to a much more daunting 17.5%. Another way to look at it: the longer you hold off, the less time there is for your savings to benefit from compounded investment returns, and the more of your own money you'll have to kick in. Waiting until age 35, for example, forces our hypothetical 25-year-old to contribute almost another $100,000 to his retirement account to achieve that $1 million balance.
The second recommendation—i.e., that millennials tilt their retirement portfolios heavily toward stocks—also makes a lot of sense. True, focusing on equities may seem like an iffy proposition to relatively inexperienced investors considering the market's short-term dips and dives and the fact that stocks lost more than 50% of their value during the financial crisis. But stocks have also demonstrated that they're capable of delivering far higher returns than less-volatile investments over the long run. Despite their volatility, stocks' likelihood of loftier long-term gains makes them a good fit for young savers who are investing money they won't tap until far into the future. Indeed, I'd argue that it's actually more risky for young investors to favor secure investments like bonds or money-market accounts over stocks, since doing so will likely lead to lower long-term returns and thus require unrealistically high rates of saving to build an adequate nest egg.
Still, following this two-pronged strategy of getting an early start on saving and investing primarily in stocks may not be enough to ensure millennials a comfortable retirement. To have a decent shot at accumulating a $1 million nest egg, or anything close, they're also probably going to have to make a concerted effort to hold the line on costs—or, to put it another way, reduce the share of their investment returns that are siphoned off by fees.
Why? Well, if predictions of low investment returns in the decades ahead pan out, even a relatively aggressive investment mix of 80% stocks and 20% bonds might return something in the neighborhood of 6.5% or so a year before expenses. Which means if our hypothetical 25-year-old wants to net the 6% annual return factored into the scenarios above, he would have to hold overall investment costs to roughly 0.5% a year. If he shells out more in fees, his net return will likely drop, which will require him to devote more of his income to savings to build that seven-figure nest egg.
So, for example, if he starts saving at 25 but pays annual fees of 1% rather than 0.5%, he'll have to boost his savings rate from 11% to 12% to have $1 million by age 67. If he incurs expenses of 1.5% a year, his required savings rate jumps jumps to 13.5%. And the later one starts saving, the more onerous the savings burden becomes. If our 25-year-old doesn't begin saving until he hits 35 and also pays expenses of 1.5% a year, he'll have to sock away almost 21% of income over the next three decades to accumulate $1 million in savings.
It's possible, of course, that the financial markets will deliver more generous returns in the years ahead. But the basic principle is the same: the more of your return you give up to fees, the more you'll have to dig into your own pocket to boost the value of your retirement accounts.
So if you're in your 20s or 30s and serious about planning for retirement, by all means start saving as soon as possible and invest the bulk of your retirement stash in stocks. But while you're at it zero in as much as possible on low-cost investments like index funds and ETFs. You'll get a bigger bang for your savings buck, and you'll increase your chances of retiring with $1 million, or building whatever size nest egg you'll need for a comfortable and secure post-career life.
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at firstname.lastname@example.org. You can tweet Walter at @RealDealRetire.
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