As a follow-up to the recent article on savings in EMC (“Savings and the time value of money”), this article drills specifically into retirement savings, which is the major savings objective of most people. Before drilling down into more detail, the conclusions are:
Start saving for retirement as early as possible, even small amounts; the time value of money makes a big difference over long periods of time,
Take advantage of the pre-tax contributions of most retirement savings plans, which means the full amount of your contribution gets channelled into savings,
Retirement savings plans allow earnings to accumulate in the vehicle on a tax-deferred basis; this means that the earnings are not taxed until they are withdrawn (or in some cases, are not taxed at all),
Many employer-sponsored retirement savings plans, like 401k’s in the US and corporate defined contribution plans in the UK, have employer matches of employee contributions up to some maximum. Employees should always take advantage of such matches, if possible up to the maximum amount that the employer will contribute,
A regimented savings plan for retirement by definition means you are probably dollar-cost averaging, a positive investment approach since prices of stocks trend higher over time, and
The difference in savings between a “normal” (non-tax-advantaged) savings plan and a tax-advantaged retirement savings plan – especially one that offers employer contributions alongside those of the employee – can be massive over time. A retirement savings plan – depending on the nature of the plan, the return and the length of time the money is saved – can accumulate four to six times as much as an ordinary (non-retirement) savings plan.
Of course, retirement savings vehicles do come with restrictions around when the money can be withdrawn. Nonetheless, this is a small price to pay for such a significant difference in future value of savings over long periods of time.
The thesis for retirement savings
The time value of money is the main reason for beginning a retirement savings programme early in one’s career – the earlier you begin saving for retirement and the longer you save, the larger your retirement pot should ultimately be. Retirement savings vehicles can be company-sponsored – like 401(k)s in the US or defined contribution pension plans in the UK – or personal, like IRAs in the US and ISAs in the UK[1]. Whether company-sponsored or personal, most retirement savings vehicles provide tax-deferred (or in some cases, tax-free) growth in the portfolio over the life of the accumulation period, a huge benefit as you will read further below. Moreover, contributions to corporate retirement savings plans and many personal retirement plans are on a pre-tax basis, meaning that the government is effectively subsidising your retirement savings. Lastly, many companies will match their employees’ contributions to their pension plans up to some specified percentage. All of these amazing benefits come with strings attached as to when the money can be withdrawn (at retirement only), so retirement savings in these vehicles truly needs to be for this long-term objective.
I will touch on these topics and the generic advantages of retirement plans in this article. However, I will not touch on specific tax nuances of each type of retirement savings plan, which vary from vehicle to vehicle and country to country. One of the many things I am not is a tax expert especially across multiple jurisdictions. Also, I will not discuss how to determine what your retirement pot target should be in this article, because a person’s retirement objectives are highly personal and depend on things like the age you wish to retire, the percentage of your pre-retirement income you wish to receive after retirement, your risk profile, and other similar attributes like these that are unique to each individual. These are topics I will discuss in a future article.
There are a number of reasons you should take advantage of company-sponsored retirement savings plans early in your career and as aggressively as your lifestyle permits. Here are a few.
Time value of money, regimented savings
If a person can afford to set aside money for retirement, he or she should. This becomes especially attractive when corporate plans, like defined contribution pension plans or 401(k)’s, provide partially- or fully-matched employer contributions alongside employee contributions (generally up to some maximum level). The time value of money means that the sooner you start saving for retirement, the better, although it is never too late to begin. Having retirement plan contributions automatically deducted from salaries might be difficult for people early in their careers because they might need every cent they earn just to cover living expenses, especially in this high-inflation environment. Nonetheless, a person should consider taking advantage of company-sponsored retirement plans, especially those that offer company matching. No amount saved is too small. Company-sponsored retirement plans normally deduct a fixed amount of your choice from your gross salary to contribute to the retirement plan. Not “seeing” the money, similar to the way that taxes and insurance are deducted from your gross pay, makes it slightly easier to set aside the money. Once you are accustomed to the money being taken out of your gross salary before pocketing the net, savings for retirement becomes more regimented and easier.
Generic tax advantages
There are two tax implications broadly speaking that make contributing to most retirement plans – especially corporate-sponsored retirement plans – attractive.
Your contributions to the plan are not taxed at the time the contributions are made. If you make $100,000/annum, your taxes would normally be $40,000 if you are in the 40% tax bracket. But if you make $100,000/annum and contribute $6,000 to a retirement savings plan on a pre-tax basis, your taxable income would be reduced to $94,000, and your tax bill would be $37,600. By contributing $6,000 on a pre-tax basis to a retirement plan, you are reducing your tax liability by $2,400. In the table I present further below, I assume that the net savings in a non-retirement plan would be $3,600, excluding taxes owed, whereas the full $6,000 would go into a tax-advantaged savings plan.
Your earnings accumulate in the plan without being taxed until they are withdrawn, meaning 100% of portfolio earnings remains in the account. This allows your portfolio earnings to compound fully each year, meaning that you earn interest on interest and dividends on reinvested dividends. Regardless of how your portfolio is constructed, 100% of the portfolio earnings is not taxed until the money is withdrawn after you retire.
Of course, the amounts in the retirement plan would be taxed in most cases when it is withdrawn during retirement while the amount in the non-tax advantaged savings would not (since it has already been taxed). This is a preferred position for most retirees because they expect to be in a lower tax bracket anyway after they retire. Also, retirees normally manage their tax liability by “timing” withdrawals to minimise their tax bill.
Company matches
As mentioned above, corporate matching inside of 401(k) plans or defined contribution pension plans turbo-charges the performance of such plans vis-à-vis generic (non-retirement) savings. Taking advantage of this matching is as close to a no-brainer as possible. I have included in the summary table below an example which has a corporate match of 4.5% of salary. For an employee making $100,000/year, this means that in addition to the employee contribution of $6,000, the employer is also putting in $4,500/annum. The effect over time is significant as you might expect given that the combined contribution of the employee and his company is now double what it was without the employer match.
How much do these advantages matter?
The table below provides assumptions and the outcome of setting aside $6,000 after-tax per annum over 35 years in three scenarios:
$6,000 is targeted to non-retirement savings. Since the money is not set aside in a tax-advantaged retirement account, taxes of $2,400 must be paid each year (assuming a 40% tax rate), so the hypothetical net amount net that the person saves is $3,600.
$6,000 is targeted to a tax-advantaged savings plan, in which the money is contributed on a pre-tax basis. As a result, the entire $6,000 is available to be saved.
Same scenario as the second except the employee’s company matches the employee contribution up to 4.5% of his salary, which is assumed to be $100,000/annum. Hence, the employee contributes $6,000 each year and the employer contributes $4,500 each year, or in total $10,500 per year, to an employer-sponsored retirement savings plan.
The table below summarises what would happen over a 35-year period, assuming historical returns on stocks and bonds and a 70/30 (stock/bond) asset mix:
Based on these assumptions, you can see that even without an employer match, a retirement savings plan (second column) results in nearly four times the amount accumulated over 35 years in a ordinary (taxable) savings plan (first column), and more than twice the amount even if the accumulated savings in the retirement plan is fully withdrawn on the retirement date (which is very unlikely). Similarly, you can see that an employer match really turbocharges returns, with an accumulation over 35 years (third column) that is nearly six times that of an ordinary (non-tax advantaged) savings plan. From this example, you should be able to easily understand the economic rationale for retirement savings.
Dollar cost averaging
One other advantage of regular savings for a retirement plan is the routine of money going into your savings plan in small increments over a long period of time. By regularly setting aside money each month from your salary to direct towards your retirement savings, and by reinvesting the earnings on assets in your portfolio over time, you will be investing on a basis that represents an average entry price for each investment over a long period of time. This strategy means you will not be “timing the market”, something even professional investors often get wrong. Rather, over a long period you will be investing in assets both when they are cheap and when they are expensive, or dollar-cost averaging. This works because over time, financial assets generally appreciate in price and benefit from reinvested earnings.
Conclusion
It’s simple: take advantage of company-sponsored retirement savings plans as much as you are able. It is best to start young, but it is never too late to start to save for retirement. By doing so, eventually the amount you set aside each month will be almost forgotten because it is taken out of your gross salary automatically. This becomes quickly regimented and often forgotten. As they say, “out of sight, out of mind.” The combination of compound earnings, company matches, pre-tax contributions, and tax-deferred earnings over time are advantages of retirement savings plans that simply cannot be ignored, especially if you desire to have as large a retirement pot as possible once you stop working.
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[1] ISAs are not specifically retirement focused but are more flexible and be used for a broader array of savings objectives.