How 1% can add $1 million to retirement
Reprinted courtesy of MarketWatch.com.
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You understand the magic of compound interest. You know about the apparent magic of dollar cost averaging. But do you know about the truly astounding magic of 1%?
If not, you’re about to find out how a few easy steps can give you an extra 1% return. The effect can be equivalent to a fireworks display when it comes time to retire.
First, the magic math of 1%. If you invest $5,000 a year for 40 years and earn 8% annually, you’ll (in theory at least) wind up with a nest egg of about $1.3 million. But if you earn 9% along the way, that nest egg grows to just under $1.7 million. The difference, roughly $400,000, is entirely the result of that extra 1% return.
This can transform your retirement from just OK to very comfortable. It can change your life as well as the lives of your family and your heirs.
If you retire with $1.3 million and withdraw 4% the first year, you have about $51,800 to help meet your cost of living. Retire instead with $1.7 million and your first-year withdrawal (again at 4%) would be about $67,500. That’s a raise of 30%!
Maybe you’re not exactly bowled over by those numbers. Frankly, I agree. But before you give up on this idea, consider this: The impact of an extra 1% return could easily be much greater, for three reasons.
- First, you are likely to save more than $5,000 a year, especially in the higher-income stage of your working life.
- Second, a two-income household could potentially double the annual investments and thus double the rewards.
- Third, if you adopt my simple suggestions and continue to get one extra percentage point of return during your retirement, it could put an extra $1 million in your pocket over the ensuing 30 years.
So, can you really get an additional 1% return over many decades? I think you can do that easily, and without much additional risk.
Here are seven steps to making this dream come true:
First , increase your portfolio’s equity allocation by 10%. If you would otherwise invest 60% in stock funds and 40% in bonds, make it 70% and 30% instead. In fact, you may want to consider eliminating bonds altogether for the first 20 years that you’re accumulating assets. This alone may contribute fully half of the additional 1% return you want.
Second , make sure you are including small-cap companies (both U.S. and international) in your portfolio. Over time this is likely to contribute at least 0.2% of your extra return.
Third , include small-cap value stocks (both U.S. and international) in the mix. As I previously described, this step has a long history of increasing returns and reducing risk. Chalk up another 0.2% of extra return.
Fourth , add large-cap value stocks (again, both U.S. and international). This could give you another 0.2% or more of additional long-term return.
Fifth , invest in low-cost index funds instead of actively managed funds run by managers who are trying to beat the market (see step #7 below). Saving on commissions, operating expenses and trading costs from high-turnover funds can easily give you the entire 1% in extra return. For the sake of this math, let’s very conservatively assume that this step nets you an extra 0.3%. (Notice that these steps have already added up to significantly more than our 1% goal.)
Sixth , If you have an employee retirement plan that’s eligible for matching contributions, make sure you contribute enough to collect every dollar of marching. Give this top priority. I can’t accurately translate that into an additional percentage return, but it can be quite significant.
Seventh , don’t second-guess the market by moving in and out depending on stock prices and your fears and insecurities. According to the best research I know, this step alone can DOUBLE your long-term return, not just add a percentage point or two.
I promised seven steps, and now you have them, along with what I think are conservative estimates of the benefits.
Here’s an eighth step, a bonus reward for reading this far. Save for an extra two years.
- If you’re just starting out, begin setting aside $5,000 two years sooner than you planned. Borrow from your parents if necessary. The long-term payoff from that extra $10,000 will likely be staggering. (Here’s the math: If you earn 9% on $5,000 invested when you’re 23, at age 65 it’s worth $186,587; do the same with another $5,000 when you’re 24 and you have another $171,181.) Don’t forget to repay your parents, along with interest; you’ll likely be able to do that in a few years when your earnings are higher.
- If you’re long past the age when you can do that, postpone your retirement for two years. You’ll save more and have two fewer years to depend on your portfolio. That means you can consider taking out 5% a year instead of 4%. That’s a 25% increase in your retirement income right there.
Now I hope you won’t start spending this money yet! Instead, concentrate on doing what it takes to get that extra 1% every year. I can guarantee that if you succeed, you — and your family — will be very glad that you did.
Richard Buck contributed to this article.