The Role of Time in Retirement Planning and Investing-Friend or Foe?
Albert Einstein reportedly said that “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
To support his point, one penny invested two thousand years ago would be worth a number with fifty-six zeros today if invested at 7% per annum. Compound interest is a key component of a broader topic which is the role of time. Despite its importance in financial planning and investing, time is the red-headed stepchild in comparison to return which dominates most investment discussions. A key point is that time can be an investor’s greatest ally, or alternatively, a fierce enemy depending upon the circumstances.
Time can be an investor’s greatest ally, or alternatively, a fierce enemy depending upon the circumstances.
As will be discussed in detail, there are two important ways to take advantage of time:
- Save and invest consistently. Start investing early in life, save an appropriate percentage of income, and defer drawing on accumulated assets for as long as possible.
- Avoid attempting to time investments given the knowledge that time allows a long-term investor to ignore (and survive) the interim ups and downs of the financial markets.
While we will cover a number of aspects of time, this paper is divided into broad segments: the advantages of time and the challenges posed by it.
The Benefit of Time – Compounding
Time provides the ability to benefit from compound interest through consistent saving and investing. While that admonition sounds like an unwelcome lecture from one’s parents, this benefit is incredibly powerful. Given reasonable assumptions regarding salary growth, returns, and annual savings, an individual who begins saving for retirement at age 25 will accumulate a portfolio that is more than 20% larger than someone who starts at age 30.
And, that translates directly into a 20%+ increase in retirement income which can radically improve the quality and security of life in the Golden Years! An alternative way to evaluate the power of compounding is to consider the required annual savings rate to achieve a comfortable retirement. Again, assuming that an individual begins a retirement savings program at age 30, an annual savings rate of about 15% of salary is required to achieve the level of retirement income recommended by most financial planners. While that figure is quite daunting, it is important to recall that many employers match contributions dollar for dollar so the employee contribution may be only one-half of that amount. The key point is that by starting at age 25 rather than at 30, the required savings rate falls to 11.5% of salary. (More than a 20% decrease)
The same principle holds true at the other end of a working career. Having started a savings program at age 30, retiring at age 70 rather than at 65 also reduces the required annual contribution by about 20%. And, in the best of all worlds, beginning the program at age 25 and remaining employed until age 70 reduces the annual contribution to about 9.5% of salary. (a 35% decrease) Given the employer match, that is a very manageable figure for most people! Of course, diligent savers may choose to maintain contributions at a higher level and enjoy greater retirement income and security. In addition to the financial considerations of remaining employed, my white paper Are the Golden Years a Myth? discussed the mental and physical health benefits of a longer career.
Saving for a child’s college education involves similar dynamics. A parent who creates a college savings program at birth will be able to contribute about 30% less annually than someone who waits until age 5!
Given the challenge of saving for education and retirement, these are very large numbers.
And, both the retirement and college savings examples are based on identical, moderate return assumptions which means the entire delta is explained by the difference in the number of years in which the portfolio is doing its work.
The Benefit of Time – Probability of Loss
We believe the best measure of risk is the probability that a portfolio does not achieve one’s financial objectives. Nevertheless, many people are hyper-focused on the chance of losing money which makes the following graph informative. It shows that the chance of losing money in stocks (after adjustment for inflation) in any given year is a little over 30% whereas the odds fall to 11.5% for ten-year holding periods and something close to zero for twenty-year periods. This graph is based on 148 years of rolling S&P 500 returns. Because the inclusion of a bond allocation tends to reduce volatility, the curve would have the same general shape for a balanced portfolio but would shift materially downward.
INSERT IMAGE 1
A very important concept that underlies this chart is the fact that time provides the opportunity to recover from downdrafts in the financial markets. Suppose one had invested in stocks at the absolute peak of the market in October of 2007. Over the following eighteen months, the price of the S&P 500 declined 56%; obviously the timing could not have been worse! However, by simply riding out the storm and not panicking, the ten-year annualized return from the peak in October of 2007 to October of 2017 was 7.5%. In other words, even given the painful initial decline, the subsequent eight-and one-half years generated sufficiently positive results to provide a very acceptable outcome. And, extending the holding period through today, the annualized return from the peak in 2007 has been 8.4%.
While it is certainly difficult to avoid severe anxiety during bear markets, the key point is that time heals all!
The Benefit of Time – Predictability of Return
One of the difficulties of financial planning is that there are so many unknowns that must be forecasted, and ultimate financial success depends upon the actual outcome for each of these variables. To name a few, it is necessary to predict salary growth, annual savings, life expectancy, inflation, and personal spending choices. And, then of course, there is the expected return on the investment portfolio. One of the benefits of time is that investment returns become somewhat more predictable. The following chart shows the range of historical returns for stocks, bonds, and a 50% stock / 50% bond portfolio over various holding periods. The data covers the period 1950 to 2022. Note that stocks have generated returns of -39% to 47% over one year periods, but the range narrows to a spread of 6% to 17% over twenty-year time frames. Because they tend to be less volatile, the range of returns for bonds is narrower for all periods, and the relatively tight band for the balanced portfolio demonstrates the value of diversification. An important point is that adding other asset categories to the mix should tighten the range for diversified portfolios even further. While the chart is visually powerful, it is important to note that even the narrower range of returns produces significant differences in the ultimate outcome. For twenty-year periods, the range of returns on the balanced portfolio was 5% to 14%. Due to the power of compounding, the 14% return produces a portfolio over twenty- years whose ending value is five times that generated by the 5% return! So, we can be a little more comfortable forecasting long range rates of return, but it is important not to overstate the value of that benefit. Given the uncertainty of future returns, financial plans should be based on realistic and relatively conservative assumptions.
INSERT IMAGE 2
The Challenge of Time – Longevity
When Social Security was created in 1935, life expectancy for men and women was 58 and 62, respectively, which suggested that overall payouts from the System would be modest given that benefits would be paid beginning at the retirement age of 65. Average life expectancy today is 76.1 years but an even more striking statistic is that 35% and 46%, respectively, of sixty-five year old males and females can expect to live to age 90. Moreover, 33% of sixty-five year old women and 25% of men can expect to reach age 95. While it seems counterintuitive to worry about living too long, increased longevity creates a real challenge in terms of accumulating sufficient assets to ensure a comfortable retirement.
Unless there is strong evidence pointing to a shorter life span due to family history or medical issues, most financial planners now recommend planning for attaining age 90, or to be certain, even 95 or 100. All other things being equal, the portfolio value required at retirement to last until age 95 is roughly twice the amount necessary assuming the average life expectancy of about 77 years!
The Challenge of Time – Running Out of Time
In an earlier section, we saw the significant benefits that result from starting a savings program at a young age and deferring retirement for a number of years. The flip side of that benefit is the significant shortfall that results from waiting too long to initiate a retirement program or saving at an inadequate rate. The best way to consider this problem is to highlight actual statistics for American savers. Twenty percent of those over age 59 have no retirement account and 25% of all Americans have no retirement savings of any kind. Unfortunately, even those with retirement accounts are in serious trouble in many cases. According to Vanguard, the median retirement account for those over age 59 has a balance of just $90,000. Without going through all of the assumptions and math, the average person at that age should have a balance of about $700,000 in order to enjoy a satisfactory living standard assuming the average life expectancy of 77 years. And, as shown above, the savings gap is even greater assuming a life span to age 90 or beyond.
Unfortunately, there is no realistic combination of market returns and/or increased savings that will attain the required portfolio-there just isn’t enough time! The sad result will be that some will never be able to retire and others will face financial pressures in what were supposed to be the carefree Golden Years. A secondary issue may be that some younger workers may face diminished job opportunities given that many older workers are unable to leave the workforce.
The Challenge of Time – The Sequence of Returns
While the annualized return on a portfolio is obviously critical, the sequence of returns is not important for long term investors who are reinvesting all of their return. To keep it simple, suppose a portfolio earns 10% in each of the first five years and then falls 10% in each of the subsequent five years. Now, assume the reverse pattern; -10% return in each of five years followed by 10% returns in each of the subsequent five years. The ending value will be the same in both cases. If you don’t believe me, do the math!
However, the picture can be very different if an investor is withdrawing money from a portfolio, say for retirement living expenses. Here is a simple demonstration:
INSERT IMAGE 3
As in the previous example, note that the pattern of returns is reversed in Example 2 versus Example 1. However, in contrast to the previous example in which no funds were being withdrawn, this retiree is withdrawing $75,000 annually for living expenses. Note that the ending value in Example 2 is 34% less than in Example 1. The key point is that a bear market at just the wrong time can seriously impact the ability of a portfolio to provide a satisfactory income stream during the remaining retirement years. This reality creates one of the most difficult tradeoffs in retirement planning and investing. On the one hand, knowledge of the impact of poor returns in the initial retirement years might suggest a very conservative portfolio that is not susceptible to a market drawdown. On the other, the combination of inflation and long life expectancy calls for a more aggressive portfolio containing a meaningful allocation to growth oriented securities. Our response to this conundrum is balanced portfolios that are less aggressive than would be appropriate in earlier years but still maintain a weighting in equities and other growth-oriented investments sufficient to provide a long term stream of retirement income.
The Challenge of Time – Time in the Market Rather than Timing the Market
While we properly focus on long term investing, very short periods of time can have a significant impact on long term outcomes. In particular, a meaningful portion of long term returns is earned in a small number of days. Take a look at the following chart.
INSERT IMAGE 4
An equity portfolio that was invested over the entire period of 6,993 trading days earned an annual return of 7.7%. However, suppose the investor was out of the market for the best five days during this period. This absence represents less than one-tenth of one percent of the trading days yet the annualized return falls to 5.9%. Following the chart to the right, missing out on the best 50 trading days (.7% of trading days) decreases the return to -1.8%. The point is that returns tend to come in small bursts so one’s greatest ally is time in the market. An additional moral of the story is that those who attempt to time the market had better get it right! (And despite a good call here and there, no one does consistently!)
Make Time Your Friend!
The key messages of this paper are relatively straightforward and they probably smack of Motherhood and Apple Pie. Nevertheless, here they are:
- Begin saving early and save aggressively. (15% of salary)
- Defer retirement for both financial and health reasons.
- Don’t be concerned about market drawdowns for most of your career; there will be plenty of time to recover.
- Use reasonable return assumptions in portfolio planning.
- Assume a long life span unless there are compelling reasons to do otherwise.
- As retirement approaches, decrease portfolio risk but not by too much.
- Do not attempt to time markets.
The two most powerful warriors are patience and time
~Leo Tolstoy