I was having the “how much does it take” conversation with someone the other day. That’s always a tough one, but perhaps tougher than ever these days.
The “how much does it take” conversation concerns how much money one needs to be financially secure. It’s always a tough call because of all the variables involved, but it is so much harder today because low interest rates are a real game-changer.
The usual variables
There are a variety of retirement calculators out there that will help you figure out how much money you’ll need in retirement, and how much you need to save year-by-year to reach that target. These calculators are useful, but what you have to remember is that they are subject to the same limitation as any calculator: garbage in yields garbage out.
Specifically, the calculations involve a number of assumptions about some key variables, and if those assumptions are wrong, the answer the calculator yields may be far off track. Here are some of the variables in play:
- Return on investment.
- Expenses in retirement.
- Income during your career.
- Length of your career.
- Interest rates.
Retirement calculations typically involve projecting these assumptions over a great many years, which means if they are even a little off to begin with, the projections may get way off track by the time you get to retirement age. For this reason, you should never look at the results of retirement calculator as a cut-and-dried answer. It is a starting point, but each year you should update your assumptions and measure where you stand relative to where you need to be.
You may find that economic conditions force you to change some of your assumptions about the future. Many long-term trends have changed these assumptions in ways that make retirement saving more difficult: people are living longer, investment returns have been sub-par for over a decade, wage growth has been anemic, and the cost of medical care has risen much more quickly than the general rate of inflation.
Even with all those challenging changes, in recent years perhaps no assumption has changed more radically than interest rates.
The declining value of wealth
According to Federal Reserve data, from the beginning of 1973 through the end of 2007 1-month CD rates averaged 6.65 percent. In the five years since, they have averaged just 0.73 percent.
That sharp drop in interest rates has effectively reduced the value of wealth. On average, from 1973 through 2007, a million dollars could produce $66, 500 in annual interest. Over the past five years, it would have produced an average of just $7, 300 in annual interest, and that figure has continued to get smaller. Even beyond how inflation may erode the value of that million dollars over time, the reduction in income production means that a million dollars is worth much less to you in retirement than it would have been a few years ago.
As a measure of wealth, this radically changes the value of accumulated savings relative to the value of employment income. The $66, 500 in income that a million dollars used to be able to produce would have been the equivalent of a decent-paying job for the typical American. In contrast, the $7, 300 in income that a million dollars has been able to produce since interest rates fell is no substitute financially for continuing to work.
We hear a lot these days that many Americans will have to work longer than past generations because of their insufficient savings habits. This is true, but if interest rates don’t rise, even people who saved diligently may have to work longer to make up for the lost savings power of their savings.
Redefining financial independence
The steep drop in interest rates and the reduced earning power of wealth as a result is one example of why the goal of financial independence is so elusive. It might be more helpful to think of financial independence as a process rather than a destination.
Think about financial independence as making your own decisions, without the influences of marketers, the government, or your peers. After all, those influences have led Americans towards lousy savings habits, by encouraging over-consumption, by reducing interest rates to nearly nothing, and by continually moving the bar for what is considered financial success.
As a destination, financial independence may be something you never quite reach, but as a process it can simply be a mindset of making decisions that are right for you, regardless of what others are doing.
Of course, that more philosophical view of financial independence doesn’t mean you should ignore the retirement calculator. That kind of calculator is important for keeping track of your intended financial destination. However, an independent attitude towards money will help you enjoy the journey to that destination all the more.