By Robin Bowerman, Head of Corporate Affairs, Vanguard Australia
The power of compound returns is startling and the mathematics in favour of starting to save early in life is undeniable.
At a 4 per cent annual return, $100,000 invested today will grow to around $580,000 over the course of a regular 45 year working life.
Vanguard’s retirement planning team has a worked example online 1. A person starting at age 20 and saving $4,500 a year has a good chance of having $1 million in retirement. At 30, they would need to save $9,000 a year. And if they wait until 40, they need to save $18,000 a year to hit the same goal.
That’s all very well for the young, but what of us that didn’t hear that lesson in our 20s and find ourselves mid-career starting to think about putting something away for retirement?
And as the old radio ad said, the best time to start might well have been 20 years ago, but the second-best time is now even with the challenges being thrown up by the COVID-19 pandemic. Not surprisingly the global health emergency has people much more focussed on short-term particularly if employment or business income has been affected.
But with more people working from home then there may be a good opportunity to devote some of that time by getting back to basics.
First things first – starting late means making a genuine effort to understand your financial plan. How much do you really need to retire? And how long do you have?
The answer to this important question will set the scene for how much you need to save. Saving for retirement is effectively a balance between your quality of life today and quality of life tomorrow.
Only once you have a plan, can you work out how much you need to save each year.
The clearest path to a comfortable retirement is to step up the amount saved each year which can only be achieved by earning more, spending less or both.
Big ticket ways to spend less include renegotiating mortgage rates lower, paying down credit card debts and personal loans and avoiding replacing things like vehicles and home appliances where possible.
Whatever path taken, the extra savings can be used to prepare for retirement in two ways – paying down debt and investing for growth.
So how to decide between those two? It is almost always best to pay down personal debts with high interest rates first. That means getting rid of those credit card and personal debts. Retiring debt free is the holy grail. Any debt repayments you need to make in retirement directly reduce the amount of money you have to spend.
The next question is asset allocation.
With a shorter timeframe a key decision is in setting realistic goals for when you retire. If higher returns will be required that generally means taking on higher risk.
A key strategy here is shifting asset allocation away from assets like cash and fixed interest towards growth assets like equities. Understanding your risk tolerance as an investor is key in this step. You will need to understand the various types of risk that each asset brings. This could be a good time to consult a financial adviser.
Historically, equity investments like stocks have provided higher returns than fixed interest investments like bonds. This higher return comes with higher risk and so a diversified approach is critical. Setting realistic goals is also where a financial adviser can add real value.
You could choose to use an index funds-only investment strategy, which aim to replicate the performance of the market or, use an active investment strategy through the use of actively managed funds that seek to beat market performance. Or, you could choose to use a blend of both.
The important thing to note about the use of actively managed funds is that they typically have higher fees than funds which seek to track the index. And higher costs will always eat away at returns.
Even if you’ve waited a long time to begin your investment journey, it is always better late than never to start planning for your retirement.
1 https://investor.vanguard.com/retirement/savings/when-to-start. Example assumes 6 per cent returns regardless of actual investment and ignores inflation for simplicity.
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