Saving for Retirement

In this topic, you'll learn:

• The unique retirement savings challenges of young (and not so young) people today.
• The power of compound interest.
• Understanding the serious long-term implications of mutual fund fees on overall returns.

Those saving for retirement today have unique challenges compared with past generations. Many companies offered pension plans that rewarded a lifetime of work with guaranteed income for their retirement years. And if you weren't lucky enough to receive a pension, at least there was Social Security. Many retirees received both a pension and Social Security.

The world is a different place today, at least for those who are not yet retired. Pensions for most private sector employees have been all but phased out over the past few decades. And Social Security's long-term funding is a topic of ongoing policy debate. Some projections suggest that without legislative changes, the program could face pressure to reduce benefits in the coming decades - though the timing and nature of any changes remain uncertain. It's worth factoring this uncertainty into your retirement planning. Needless to say, for those still in the workforce, starting to think about retirement planning sooner rather than later can make a meaningful difference - especially given the uncertainty ahead.

For many people, starting a retirement savings plan early is one of the most impactful steps they can take - though the right approach depends on individual circumstances, including income, existing debt, and financial goals. For many people, building retirement savings - alongside other assets they may accumulate over time - means that a comfortable retirement doesn't require extraordinary wealth. And if you're relatively young, you don't necessarily need a lot of money now to secure your retirement, you have something just as valuable - time.

So let's explore the potential benefits of compounding and some of the factors that may improve or reduce our long-term investment returns. 

Please keep in mind that the examples below are illustrations only - actual outcomes depend on your specific investments, fees, contribution amounts, and market conditions, which will vary.

The Power of Compounding

When you plan to grow wealth over a lifetime, one of the most important concepts to understand is compound interest. Compound interest arises when interest is added to the principal, so from that moment on, the interest that has been added becomes the principal and also earns interest. So if you saved $100 that earned 8% interest per year, at the end of the first year you would have $108. During the second year, interest is earned not only on the first $100, but the additional $8 - for a total of $116.64. That extra 64 cents may not sound like much, but over a lifetime, the effect can be substantial.

Here's an example - say someone starts saving $200 per month at age 22 and saves until they're 65. If their investments averaged an 8.5% annual return (a figure based on historical stock market averages), the account could hypothetically grow to over $1,000,000 - all for $200 per month. However, actual returns vary year to year. Investments can lose value, and past performance does not guarantee future results.

But what happens if you don't start saving until you are 40 years old, cutting your years of contribution and compounding from 43 to 23? Rather than over one million dollars, you would be left with a somewhat less impressive $167,000.

Or what if you had simply saved $3,000 from a summer job each year during college and never added another dime? That $12,000 investment at an 8.5% return would be worth over $450,000 at age 65 all because of compounding - not bad at all.

These examples assume a rate of return that's based on past averages (nobody can tell the future) and they also assume tax-free growth in an IRA, 401(k) or similar account. But they do serve to illustrate an important point - by starting early, you can dramatically increase your returns and your quality of life at retirement.

The Consequences of Investment Fees

There is a time when compounding actually works against your overall returns, and that's when you include the management fees typical of many mutual funds. Also known as the "expense ratio," this fee can take a substantial bite out of your savings. A typical expense ratio for a mutual fund is 1.19% - meaning that 1.19% of your total balance is taken each year as a management fee. So if you had an account worth $100,000, you would be paying nearly $1,200 per year in fees. And these fees are paid regardless of whether you made or lost money that year.

To illustrate the impact of fees, consider the earlier hypothetical example: a $200/month contribution over 43 years at an assumed 8.5% average annual return. Under that hypothetical scenario, the ending balance might be approximately $1,050,000. After subtracting a hypothetical 1.19% annual expense ratio, that figure drops to roughly $721,000 - a difference of about $329,000, or 31%. Adding a hypothetical 5% front-end load reduces the total further to approximately $649,000, and a 5% back-end load brings it to around $616,500.

In addition to the expense ratio, some mutual fund companies charge a "load," or fee on the purchase and/or sale of mutual fund shares. The fee upon fund purchase is called a "front-end" load, the fee on the sale of the fund is known as a "back-end" load. So in our example, putting our hypothetical investment in a fund with a 5% front end load would reduce the total by approximately $72,000, leaving a total of $649,000. If the fund also charged a 5% back-end load, that would reduce the total by another $32,500, leaving a final balance of $616,500 - that's a total difference of $433,500 (or 41%) of our original example, all because of a 1.19% management fee and 5% front and back-end loads.

When evaluating investment options, pay close attention to the expense ratio and load percentages - they can make a much bigger difference than one would ever expect. Management fees can have a significant impact on long-term investment returns. When evaluating investment options, comparing expense ratios and understanding how fees affect your potential returns over time can be an important consideration.

Asset Allocation

Because each of the main three types of investment classes involve different levels of risk and reward, you will often hear the term "asset allocation" in regard to investment planning. Asset allocation simply means the percentage of your entire investment portfolio that is invested in each of the three main asset categories.

Younger investors with many years before retirement sometimes choose a higher percentage of stocks, which historically have offered greater growth potential along with more volatility. As retirement approaches, some investors gradually shift toward a higher proportion of bonds and cash to help preserve what they've saved - though the right mix depends on your individual risk tolerance, timeline, and goals. A financial advisor can help you think through an allocation strategy that fits your situation.