Grab the Roadmap

FINANCIAL SECURITY is within your reach. Don���t believe me? Here���s a roadmap that demonstrates it���s possible for most Americans.

Sam is a 22-year-old college graduate. He begins working right after college, earning $50,000 a year. He saves 20% of his income the first year, equal to $10,000. Each year, he gets a 2% raise. This raise is over and above inflation, which we���ll assume is zero to keep things simple. In addition to saving $10,000 a year, he takes half his annual raise and also socks that away.

For example, in his second year on the job, his salary increases from $50,000 to $51,000. He takes half the raise, or $500, and adds that to his annual savings of $10,000, so he saves $10,500. He continues in this manner year after year. Since he���s saving half of each year���s raise, his savings rate slowly increases, reaching 25% at age 32 and 30% at age 43. Sam also consistently invests his savings, getting a long-term average annual return of 6.2%. More on that number later.

Meanwhile, Sam���s standard of living isn���t stagnant. His annual spending rises from $40,000 right after college to $50,000 by age 40 to a little over $60,000 by age 53.

What���s happening to his nest egg? By age 49, Sam has become a millionaire. The year before he became a millionaire, Sam���s cost of living was $56,000. That means, if he retired at 49 and wanted to maintain his current standard of living, he would need to draw 5.6% from his nest egg.

Sam is a conservative guy and thinks 5.6% is too high. Maybe he could swap to a less stressful job with more time off, taking a 50% pay cut in the process. Since he made $82,000 the previous year, a 50% pay cut would mean an income of $41,000. Now, he only needs to draw $15,000 from his nest egg to maintain his $56,000 lifestyle, which would equate to a 1.5% withdrawal rate. That sounds a lot better.

While it sure feels good to know he has options, 49-year-old Sam isn���t quite ready to throw in the towel. He continues to work and save as he���s been doing. Nine years later, at age 58, his nest egg has grown to $2,108,000. Sam is now seriously contemplating a career change or maybe even outright retirement. Can he pull the trigger? You bet. If Sam were to withdraw 4% of his nest egg���based on the popular 4% rule���that would equate to an annual income of a little over $84,000. That���s $20,000 more than he spent the previous year. Not only can Sam retire, but also he could seriously upgrade his lifestyle.

Notice that it took Sam 27 years to become a millionaire, but only nine additional years to reach $2 million. Any guess on how many years it would take Sam to get to $3 million? Just five years. These numbers demonstrate the power of compound interest. Even if Sam stopped saving once he became a millionaire at age 49, his nest egg would still grow to $2 million. Instead of taking nine years, it would take 12 years���just three years longer.

Are my assumptions realistic? The first set of assumptions are largely outside of our control. I call these the��financial��assumptions:

Sam had a starting income of $50,000 a year. As it happens, the average starting salary for a bachelor���s degree graduate was just over $50,000 for the last three years, according to the National Association of Colleges and Employers. Median household income reported by the U.S. Census Bureau for 2016 was $59,039.
Sam���s income grew 2% each year. Median wage growth since 1983 has been 4% a year. Subtract 2% inflation and you get 2% real��income growth.
Sam���s savings collected an average annual return of 6.2%. This number comes from assuming an 80% stock-20% bond portfolio and using real��long-term rates of return of 7% for stocks and 3% for bonds. While we���ve enjoyed such performance historically, there���s a good chance returns will be lower going forward. But that doesn���t change our story much���because what drives Sam���s success, more than anything, is his savings habits.

The second set of assumptions are largely within our control.�� They are what I call the personal��assumptions:

Sam begins to save at age 22, which is the age many young adults graduate from four-year colleges.
Sam saves 20% of his income right off the bat.
Sam takes half of every annual raise and adds it to his yearly savings.

I can already hear the objections: ���Save 20% or more of my income? Get real. Maybe you can do that if you���re making a six-figure income, but otherwise you���re out of your mind. I can barely make ends meet living on $50,000.���

Here���s my rebuttal: If $50,000 covers the bare necessities of life, how are those earning $40,000 surviving? Alternatively, what about those families earning $62,500? Surely they can live off 80% of their income���which would be $50,000���and save 20%? My point: Saving 20% of your income is never easy, because it means denying yourself things that you have the means to obtain right now.

But what���s the alternative? The savings rate has hovered around 6% recently. If we run the same scenario as before, but change the savings rate to 6% and the name to Frank, here���s what we find:

Frank reaches the $1 million mark at age 69 and $2 million at age 80.
If Frank retires at 69 and uses the 4% rule, he would have annual income of $41,000. Just before quitting the workforce, however, he had been spending $116,000 a year.

The bleak reality: A 6% savings rate means the financial milestones take many more years to reach. Frank waits two decades longer to become a millionaire. Even worse, the low savings rate equates to a higher spending rate, meaning Frank is faced with a difficult decision at age 69. He can retire and massively downgrade his standard of living���or he can keep working.

Will you be a Sam or a Frank? Just remember the truism that applies not just to personal finance, but to all walks of life: You can have it easier now and harder later���or harder now and easier later. What about easier now and easier later? Lots of folks behave like that���s a choice, but it isn���t.

John Lim is a physician who is working on a finance book geared toward children. His previous blogs��were Bearing Gifts and�� Lay Down the Law . Follow John on Twitter @JohnTLim .

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