It’ll Cost You
IT���S IRONIC that we often shortchange retirement savings during the first half of our working lives, because that���s when we can buy future retirement dollars at a huge discount���thanks to investment compounding.
How can we hammer home this point? My proposal: We should adopt a simple mental math rule that allows us to weigh today���s spending against future retirement dollars. That brings me to my ���6 to 2 times 200��� rule. The rule covers five age groups: early 20s, late 20s, early 30s, late 30s and early 40s.
The first part of the rule���the ���6 to 2��� part���gives the compounding factor for each age group. For instance, the compounding factor is six times if you���re in your early 20s, five times if you���re in your late 20s, and so on. As you grow older and enter the next age group, the compounding factor drops by one. What does all this mean? Each $1 spent by folks in their early 20s means at least $6 less in retirement spending. Similarly, $1 spent in your early 40s means at least $2 less in retirement.
Admittedly, the rule is only an approximation. Still, with any luck, it���ll help us to pause before spending. For instance, it will make a 27-year-old realize that switching to that shiny new $1,000 iPhone could cost as much as $5,000 in retirement spending. Is it worth effectively spending $5,000 on a new phone?
Our 27-year-old may still decide to switch to the new iPhone. After all, we all make bad spending decisions and we usually get away with, provided the bad decisions aren���t too frequent or too costly. Instead, the real damage often comes from recurring expenses���the monthly magazine that no one reads, the extra property taxes for the bigger-than-needed house and countless similar items.
This is where the second part of the rule���the ���times 200��� part���comes into the picture. Suppose our 27-year-old is looking at an unlimited data plan that costs $25 a month extra. To figure out how much this means in lost retirement spending, we would multiply the $25 by five, which is the age factor, and then by 200, because it���s a recurring monthly expense. Result: Opting for the data plan means giving up perhaps $25,000 of retirement spending.
To put it another way: $1 of recurring monthly expenses over your working life dents your ultimate nest egg by $1,200 if you���re in your early 20s, $1,000 if you���re in your late 20s, $800 if you���re in your early 30s, and so on.
Is the ���6 to 2 times 200��� rule accurate? Some argue that the cost of a daily latte for a 22-year-old amounts to $1 million. My rule puts it at a relatively modest $120,000, assuming each latte costs $3.33. Why the big difference? I���m using an inflation-adjusted “real��� investment return of 5%, so the numbers aren���t distorted by inflation. That means that, if the rule says $10 spent every month is costing you $10,000 in retirement, those two numbers have similar purchasing power. But however you do the calculation, the lesson is clear: A recurring expense is far costlier than it appears.
Curious about where the numbers come from? They assume you work until around age 60. The compounding factor���the ���6 to 2��� part���comes from eyeballing the future value of a dollar invested for various time periods. The lump sum conversion of the monthly recurring payments���the ���times 200��� part of the rule���is the aggregate present value of the payment streams involved.
As you might gather, I���m not swearing that the ���6 to 2 times 200��� rule gives the exact right answer. But precision isn���t the point. Instead, the goal is simplicity, so the rule is easy both to remember and apply. The idea: Get ourselves to pause before we spend���and ponder how much an item is truly costing us.
A software engineer by profession, Sanjib Saha is transitioning to early retirement. His previous articles were Mind the Trap,��A Rich Life and��Cost of Living. Self-taught in investment and financial planning, Sanjib is passionate about raising financial literacy and��enjoys helping others with their finances.��Earlier this year, he passed the Series 65 licensing exam as a non-industry candidate.��
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