How to Save for Retirement

When people save for retirement, what action contributes the most to their success? Casual observation suggests that most people consider the selection of investments and the amount saved to be paramount. This is wrong. To see why, consider the following example.

The Early Bird Gets the Apple, Not the Worm

First, assume a saver begins saving at age 20 for retirement at age 65. The saver sets aside $10,000 received in an inheritance. The saver earns an average annual return of 8% on the savings and reinvests all earnings. Unfortunately, the saver is unable to add any additional money to this additional contribution, so the total contributions to the saving program total $10,000. Contrast this with a second possibility, in which the saver doesn’t start saving until 10 years later, at age 30. Again, the purpose is to save for retirement at age 65 and the average return on investment is 8%.  This time, however, the saver is able to put away $100 per month ($1200 per year) for the next 35 years, contributing a total of $42,000 – over four times more than in the first case. Which saving program will yield the largest total wealth in retirement at age 65?

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The second program will yield a total of nearly $207,000. The first program, however, will yield just under $320,000. The advantage enjoyed by the first saving program does not come from the amount saved, because the second program saves between three and four times more money in total. The first program does not enjoy an advantage in the rate of return on savings, which is 8% in both programs. The huge advantage to the first savings program comes entirely from its 10-year head start. This enables compound interest to work its magic on the wealth created by the saving program. The fact that an interest return is earned not only on saving contributions but also on the reinvested returns is the key to the first program’s wealth-building advantage.

Save Early and Often

This example highlights the first and most important guideline in the primer on how to save for retirement: Start early. That is the way to get the maximum result from the minimum effort contributed to the process. The purpose behind all economic activity is consumption and saving is the sacrifice of current consumption for the purpose of creating wealth for future consumption. Maximizing happiness involves sacrificing as little current consumption as possible to gain as much future consumption as feasible. Figuratively speaking, compound interest is a machine for building wealth. The early start allows the machine to do more of the work, making it easier on the worker.

The words “early start” can have a discouraging effect on the would-be saver by suggesting that it is “too late” for anybody who doesn’t begin their saving program in their twenties or thirties. Since history cannot be replayed and more wealth is always better than less, the real lesson is that the best time to begin saving is immediately. The past is unrecoverable; only the present and future can be affected by our actions.

Savings Priorities – the Four Properties of Economic Assets

The second guideline in how to save for retirement is to appreciate the four properties of economic assets – growth, income, safety, and liquidity. A successful program of retirement saving will assign the proper role to each of these. That role will depend on which stage in the financial life cycle the saver currently occupies.

During young adulthood the saver had two preoccupations – growth and liquidity. The saver doesn’t need income from assets; income is earned on the job. Safety is a luxury that the saver doesn’t need and can ill afford. It isn’t needed because the saver has a career to recover from mistakes and financial reverses. It is a questionable luxury because this is the only time when the saver will be able to pursue growth wholeheartedly – and that pursuit means pushing safety into the background. The first rule of finance is the tradeoff between risk and return. At this point, the saver should allocate the largest share of assets to growth-oriented investments, such as stocks or mutual funds. That does not mean the stock portfolio should not be diversified, but it does mean that fixed-income investments should be held to a minimum.

Liquidity is the other preoccupation in young adulthood. A minimum of 3-6 months’ income should be set aside in cash-equivalent assets such as money market accounts. This is intended to cope with the loss of a job, a child’s illness, the replacement of an automobile, or an expensive home repair. The odds of at least one such emergency cropping up in a lifetime are very good indeed.

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Saving for Retirement in Middle Age

In middle age, these priorities will change. Young adults should pursue growth more or less blindly. It is too much to ask them to know their own tolerance for risk when they have experienced so little of the world. By middle age, they should know themselves well enough to tailor their portfolios to their own personalities. There is still little need to take income from assets. The need for growth is still pressing, but this may be modified somewhat by their growing understanding of the tradeoffs involved. Thus, safety may begin to intrude on their consciousness. Liquidity is less important in the absolute sense because children are grown or growing up and assets have been upgraded. It is less important in the relative sense because they are in their prime earning years, so their emergency fund will comprise a much smaller fraction of their assets. The upshot of all this is that they will save more than ever, but the composition of their saving may change somewhat.

Saving for Retirement After Age 50

Beginning in late middle age – after age 50, say – savers are now taking dead aim on retirement. This is the ideal time for security-conscious savers to purchase a deferred annuity, timed to begin distributions at retirement age. Alternatively, less risk-averse savers may still pursue an aggressive growth agenda by allocating assets strongly towards equities. This is the point at which even aggressive savers should begin to take safety into account by reallocating assets toward fixed-income, secure categories such as bonds, CDs, and annuities. With retirement looming, there are only a few years in which to recover from losses of principal value.

Saving in Retirement

It is tempting to dismiss the retirement years simply by saying that income becomes paramount, with safety and liquidity also gaining in importance. Immediate annuities come into their own as the best way to convert lifetime retirement savings into guaranteed income for life. That is true enough, but incomplete. The lengthening of life expectancies means that growth can still be necessary and desirable even after retirement. The trick is getting a modicum of growth without sacrificing the other three goals. Indexed annuities offer one possible avenue toward this end. It would certainly be fair to say, however, that retirement is a time for dissaving rather than saving – that is, for using up the accumulated savings of the past in order to consume more than is received in income.

Insuring Against Disaster

One significant consideration has been completely bypassed in the discussion so far. That is the need for what might be called a disaster fund – assets whose growth will offset the effects of economic depression, hyperinflation, or natural catastrophe. The traditional, logical repository for such assets is gold. Gold does not earn interest and its record of growth in ordinary times is not particularly strong. It is simply the best-known, most reliable hedge against calamity. When money ceases to perform its key function as a store of value because its purchasing power has been debased, people turn to gold. Their demand drives up the price of gold, rewarding its owners. Gold holdings should represent only a small fraction of the portfolio, perhaps 5% at most.


The most important element of successful retirement saving is an early start, which allows compound interest to do the heavy lifting of building wealth for retirement. Recognition of the four properties of economic assets – growth, income, safety, and liquidity – enables the saver to prioritize properly during each stage of the financial life cycle.

Growth and liquidity predominate in young adulthood; savers should pursue growth aggressively while keeping an emergency fund on hand. Growth still heads the agenda in middle age, but savers begin to accumulate the expertise and self-knowledge to refine their portfolios according to their risk tolerance. After age 50, savers take dead aim on retirement. Security-conscious ones start annuities to create lifelong income, while others pursue growth while gradually reallocating assets in favor of safety. Retirement is the time to take income from assets; safety and liquidity also assume increased importance. Increased life expectancies create the incentive to find the least-risky way to preserve a modicum of growth.

In any stage of life, it is reasonable to hold a disaster fund comprising a small percentage of total assets. Gold is the traditional component of that fund.

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