Skip to main content

Investors spend endless hours pondering things they can’t control, such as stock prices and the economy. They spend far less time thinking about the one thing they can control – the amount of money they save.

Maybe we should reverse our priorities. In any ranking of sexy topics, saving money ranks just ahead of lint removal or periodontal health. But when it comes to determining our eventual wealth, savings is the key input that underpins everything else.

That’s especially true in our low-return world – a fact that struck me recently when a friend asked how much money his daughter should be putting away from her paycheque.

She’s in her mid-20s and just landed her first job in her chosen field. Like nearly all of us at that age, she sees saving money as a distant priority – something to start worrying about in a couple of decades. Her immediate goal is to buy a condo and pay it off. Amassing an investment portfolio can wait.

It’s easy to sympathize with her viewpoint. But my friend’s question spurred me to build a simple spreadsheet that demonstrates some of the issues involved with waiting to build a nest egg, especially for an upwardly mobile young person like his daughter.

I assumed she would start out earning $50,000 a year. She would earn rapid raises over the next 15 years and boost her income to about $100,000. At that point, the raises would slow. Her salary would creep upward for the next 15 years, eventually hitting a peak around $133,000. Five years later, she would leave work, after a successful 35-year career.

How much money should she have stashed away for retirement on the day she walks away from the office? One rule of thumb, propounded by Fidelity Investments and others, says she should aim to have 10 times her final annual salary.

That’s an intimidating target, but there’s logic behind it. If history is any guide, you can count on withdrawing an inflation-adjusted 4 per cent of your initial nest egg every year in retirement. So a retirement stash that starts out at 10 times your annual working income will likely be able to replace about 40 per cent of what you used to earn. Add in Old Age Security and Canada Pension and you’ve achieved a decent retirement income.

There are, of course, many caveats to that 10-times target. People who make smaller incomes may find that OAS and CPP go a long way to replacing their working incomes, so they don’t have to save as much. People who work at organizations with defined-benefit pension plans may also find their retirement needs are largely covered.

However, many more of us should be pondering what it would take to hit the 10-times target. The trickiest aspect is predicting how well your investments will do over several decades.

Results are uneven. Between 1982 and 2000, investors in both stocks and bonds reaped big returns. Since then, stock-market profits have been choppy and bond yields have fallen to dismal lows.

The Financial Planning Standards Council issues regular updates on what it regards as reasonable long-term assumptions for portfolio returns in Canada. Last year, it estimated that a standard balanced portfolio, composed of equal measures of stocks and bonds, should be able to generate an average annual return of just under 4 per cent a year, once all fees are deducted.

This brings us to the nub of the issue: Assuming a 4-per-cent rate of return on her portfolio, my friend’s daughter will have to save 20 per cent of her income every year to hit her retirement goal.

I can understand why she might balk at the thought of putting away 20 per cent a year of her salary. Maybe her condo will soar in value. Maybe investment returns will be better down the road.

Fair enough. But even if she manages to achieve an average annual return of 6 per cent, she’s still going to have to put away 14 per cent of her income on average.

On top of that, there’s a question of risk.

If she starts saving early and returns are better than projected, that’s great. She can ease back on her savings regimen. But if she defers saving for the first 15 years of her career, and future returns are no better than expected, she’s going to have to put away massive portions of her income – on the order of 40 per cent a year – to arrive at her desired retirement goal.

All things considered, starting to save early sounds like the much better alternative.