After my husband read our net worth update, he asked why our portfolio was declining and if contributions wouldn’t offset the declines. I explained that we had reduced our savings contributions significantly in the last few years, which alarmed him.
Actually, the strategy I came up with is anything but alarming. Here’s an example of how it works. We’ll use the following data points for the illustration:
- Starting salary for couple: $100,000
- Salary increases per year: 4%
- Yearly return on portfolio, compounded annually for simplicity: 8%
- Time frame: 25 years
- (We’ll ignore inflation for this exercise)
Static Contribution Percentage
Typically, someone will select a contribution percentage for their retirement plans. We’ll use a 5% contribution. Often years go by and the percentage remains static. The great part here is that the individual is saving. In our example the couple will have saved $523,000 after 25 years!
Increasing Contribution Percentage
One of the popular methods for saving for retirement is to increase your contribution percentage each year. Timing it with your raise often means you won’t notice a decrease in your take-home pay. This is a terrific model for saving for retirement and yields a substantial gain over the static model.
Increasing the contribution by 1% each year will yield over $1,000,000 after 22 years. In addition, after 25 years the portfolio will be worth $1.6 million! Here’s a graph showing the savings percent plotted against the portfolio value.
Decreasing Contribution Percentage
A strategy that doesn’t get a lot of thought is one that reverses the common increasing contribution percentage. Starting the percentage out very high and decreasing it by 1% each year yields much more than the increasing percentage strategy.
If the couple starts at 30% and decreases their contribution by 1% each year the portfolio will hit the $1 million mark after only 17 years. In addition, the portfolio will be worth $2.1 million after 25 years.
The total contributions for this example were actually less in total than the increasing model ($133,000 less). In addition, with this strategy, there is the ability to stop contributions all together at some point in the future, as they eventually become irrelevant in terms of relative value.
Here’s a graph showing the three different strategies and the portfolio values over time.
Having been a saver since I was a kid I started us on an incredibly aggressive savings plan. We contributed over 50% of our salary to our retirement portfolio from the start. We then backed it down to 40% when we started building our new house. After we had kids is went to 25% and just recently we lowered it to 15% for our 2008 budget.
It was very easy to save aggressively in the beginning because we didn’t have huge financial commitments that often come a little later in life (mostly a house and kids). Now that we don’t have a big need to save much anymore we can direct some of that money towards other things.
Of course, we still save a high percentage of our income when comparing it to other families.
How are you saving for retirement?
This article is featured in: Carnival of Personal Finance #143.