Why Save for Retirement in Your 20s?

When you’re in your 20s, retirement seems so far off that it hardly feels real at all. In fact, it’s one of the most common excuses people make to justify not saving for retirement. If that describes you, think of these savings instead as wealth accumulation, suggests Marguerita Cheng, CFP, CEO of Blue Ocean Global Wealth in Rockville, Md.

Anyone nearing retirement age will tell you the years slip by, and building a sizable nest egg becomes more difficult if you don’t start early. You'll also probably acquire other expenses you may not have yet, such as a mortgage and a family.

You may not earn a lot of money as you begin your career, but there’s one thing you have more of than richer, older folks: time. With time on your side, saving for retirement becomes a much more pleasant—and exciting—prospect.

You’re probably still paying off your student loans, but even a small amount saved for retirement can make a huge difference in your future. We’ll walk through why your 20s are the perfect time to start saving for those post-work years.

Know Your Goals

The sooner you start saving for retirement, the better it will be down the road. But you may not be able to do it yourself. It may be necessary to hire a financial advisor to help you out—especially if you don't have the know-how to navigate the process of retirement planning.

Make sure you set realistic expectations and goals, and make sure to have all the necessary information when you meet with an advisor or start mapping out a plan on your own. A few things you may need to consider during your analysis:

• Your current age

• The age when you plan to retire

• All income sources including your current and projected income

• Your current and projected expenses

• How much you can afford to set aside for your retirement

• How and where you plan to live after you retire

• Any savings accounts you have or plan to have

• Your health history and that of your family to determine health coverage later in life

Compound Interest Is Your Friend

Compound interest is the best reason it pays to start early with retirement planning. If you’re unfamiliar with the term, compound interest is the process by which a sum of money grows exponentially due to interest more or less building upon itself over time.1

Let’s start with a simple example to get down the basics: Say you invest $1,000 in a safe long-term bond that earns 3% interest per year. At the end of the first year, your investment will grow by $30—3% of $1,000. You now have $1,030.

However, the next year you’ll gain 3% of $1,030, which means your investment will grow by $30.90. A little more, but not much.

Fast forward to the 39th year, you can see that your money has grown to around $3,167. Go ahead to the 40th year, and your investment becomes $3,262.04. That’s a one-year difference of $95.

Notice that your money is now growing more than three times as quickly as it did in year one. This is how “the miracle of compounding earnings on earnings works from the first dollar saved to grow future dollars,” says Charlotte A. Dougherty, CFP, founder of Dougherty & Associates in Cincinnati, Ohio.

The savings will be even more dramatic if you invest the money in a stock market mutual fund or other higher-earning vehicles.

Saving a Little Early vs. Saving a Lot Later

You may think you have plenty of time to start saving for retirement. After all, you are in your 20s and have your whole life ahead of you, right? That may be true, but why put off saving for tomorrow when you can start today?

If you have access to an employer-based retirement plan, take advantage of it. Most employers will match some of your contributions, so you'll benefit from having an extra boost to your savings. And with pre-tax deductions, you won't even notice your money is being put away.

You can also put money aside outside of your employer. Let's consider another scenario to drive this idea home. Let’s say you start investing in the market at $100 a month, and you average a positive return of 1% a month or 12% a year, compounded monthly over 40 years. Your friend, who is the same age, doesn’t begin investing until 30 years later, and invests $1,000 a month for 10 years, also averaging 1% a month or 12% a year, compounded monthly.

Who will have more money saved up in the end?

Your friend will have saved up around $230,000. Your retirement account will be a little over $1.17 million. Even though your friend was investing over 10 times as much as you toward the end, the power of compound interest makes your portfolio significantly bigger.

Remember, the longer you wait to plan and save for retirement, the more you'll need to invest each month. While it may be easier to enjoy your 20s with your full income at your disposal, it will be harder to put money away each month as you get older. And if you wait too long, you may even need to postpone your retirement.

What to Consider When Investing

The types of assets in which your savings are invested will significantly impact your return and, consequently, the amount available to finance your retirement. As a result, a primary object of investment portfolio managers is to create a portfolio that is designed to provide an opportunity to experience the highest return possible. Amounts that you have saved for short-term goals are usually kept in cash or cash equivalents because the primary objective is usually to preserve principal and maintain a high level of liquidity.2 Amounts that you are saving to meet long-term goals, including retirement, are usually invested in assets that provide an opportunity for growth.

If you manage your investments instead of using the services of a robo-advisor or professional, it is important to understand that there are other factors to consider. The following are just a few:

Market Risk

The investments that provide the opportunity for the highest rate of return are usually the ones with the highest level of risk, such as stocks. The ones that provide the lowest rate of return are usually the ones with the least amount of market risk.

Risk Tolerance

Your ability to handle market losses should be factored in when designing your investment portfolio. If the amount of market risk associated with your portfolio causes you undue stress, it may be practical to redesign your portfolio to one with less risk, even if it is determined that the amount of risk is suitable for your investment profile. In some cases, it may be practical to ignore a low level of risk tolerance if it is determined that it negatively impacts the ability to provide your investments with sufficient growth.

Generally, the level of discomfort one experiences with risk is determined by one's level of experience and knowledge about investments. As such, it is in your best interest to, at a minimum, learn about the different investment options, their market risks, and historical performance. Having a reasonable understanding of how investments work will allow you to set reasonable expectations for your return on investments, and help to reduce the stress that can be caused if expected returns on investments are not achieved.

Retirement Horizon

Your targeted retirement age is usually taken into consideration. This is usually used to determine how much time you have to regain any market losses. Because you are in your twenties, it is presumed that investing a large percentage of your savings in stocks and similar assets is suitable, as your investments will likely have sufficient time to recover from any market losses.

The Bottom Line

The sooner you begin saving for retirement, the better. When you start early, you can afford to put away less money per month since compound interest is on your side. “For Millennials, the most important thing about saving is getting started,” says Stephen Rischall, co-founder of 1080 Financial Group. “Compounding interest benefits those who invest over longer periods the most.”

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Steven Richmond, Investopidia

12 November 2020