Friday, January 8, 2010

5 Reasons Why Extra Cash Should Go To Retirement ASAP

In a recent post, an associate posed the following question:
 -- My fellow associates have a vague idea that they 'should' be saving for retirement, but don't understand why waiting just five years is so detrimental. I've tried explaining the power of compounding to a few, but to little avail.
First, let me acknowledge that it is really tough to get a good legal job these days -  and even if you go get a good legal job, you often have a crushing amount of debt and your expenses may not leave you with much (if any) free cash for investing.  However, for the sake of this post, we will assume that by some rare good fortune, an associate has gotten a good job and has a little extra money above the associate's subsistence needs.  Consequently, the associate is faced with the choice of whether to buy toys now (which gives pleasure today) or save/invest the extra for the rather nebulous goal of "retirement."  However, retirement seems so far away that it is difficult to even conceive of it.  Also, the associate thinks that they will be making more money later, so it will be even easier to save for retirement later - so why deny themselves today?  Besides, they deserve it! 

I can't control the choices that the associate will make, but I want to be sure that the associate fully understands the consequences of their action (or inaction) - and how investing for retirement right away will actually turn out to be the cheapest, easiest, and least painful way to have enough for retirement.

1. First, let's compare the stories of Associate A and Associate B.  Associate A invests $2,000/year from age 25 to age 35 - and then stops and never invests another dime.  Associate A's total investment is thus $20,000.  Conversely, Associate B decided not to invest at 25 and delayed starting to invest until 35.  Associate B also contributes $2,000/year, but Associate B contributes $2000/year from age 35 until his retirement at age 65.  Associate B has thus contributed $60,000 - three times as much as Associate A.

At first glance, it would seem like Associate B would have a lot more at retirement, right?  After all, Associate B saved/put away three times as much as Associate A.  Also, by the time that Associate A also retires at 65, Associate A will not have invested anything for 30 years - while Associate B will have been diligently saving for each of those 30 years.  It's only fair that Associate B's investments are worth more in retirement, right?


Here's a chart of the scenario we described above assuming a 10% rate of investment return.  As you can see, the "slacker" that only invested for 10 years and then stopped has about $611K in his account, while the "sucker" who delayed 10 years, but has been contributing for 30 years only has about $361K in his account.  Associate A - who hasn't had to invest a dime for 30 years - has about 70% more than Associate B.  This chart is from this page at GenXFinance.

Do you think a 10%/year return is too aggressive, here's a similar result with an 8% rate of return.  In this case Associate A still comes out ahead, but a little less - Associate A has about 40% more than Associate B at retirement.

Bottom line, by contributing just a little up front, you are setting yourself up for easy street later.

2. Let's take a slightly different take.  Let's say Associate A starts investing $3600/year at age 25 and continues to retirement.  Associate B does not begin investing until 35, but because he feels like he is having to play catch-up, Associate B invests $7,200/year from age 35 to age 65.  Associate B is investing TWICE what Associate A is investing from age 35 to age 65.  Let's also add Associate C, who does not start saving for retirement until age 45, but invests $14,400/year from age 45 to age 65.  Thus, Associate C is investing 4 times as much as Associate A from age 45-65.  let's assume an investment return of 8% for all the Associates.

At first glance, it would seem like Associate C -who is putting away 4 times as much than Associate A for 20 years! - somehow "deserves" to have the most at retirement.  Also, we note that Associate C will have actually made the greatest contributions to the retirement account - $288K - as opposed to Associate A's $144K.  Associate C has contributed twice as much to his retirement, surely his account is of greater value.

Wrong Again!

Although the difference is a little closer this time, if you wait until 35 to start investing, then even if you invest twice as much you are not going to catch up to the person who started at 25.  You will be about $100K behind.  Similarly, if you wait until 45, you are going to be about $200K behind.

Another thing to note is that by contributing only $3600/year and getting only an 8% return, Associate A has about $1,000,000 at retirement.  This chart is from the Observations blog here.  That really does not seem that difficult of a way to make it to $1 million, does it?

Bottom line, if you start at 25, it is going to be so much less painful to invest over your entire career.  Further, some associate thinking that they can just catch up by starting to invest in the future is probably not accurate.  They would have to invest so much more that it would put a much greater crimp in their lifestyle.

3. The third reason why your extra cash should go to retirement ASAP is because you never know what the future holds - you could get fired pretty much any day.  What if you get fired after 5 years (at age 30) and are forced to take a very low-paying job and can't make any future investments?  Well, if you invested $2000/year just for the first 5 years, and earned 10%, you would still end up with about $300K at retirment.

Let's face it, the legal marketplace is quite volatile.  In many firms, it's up or out and only 1 in 10 incoming associates makes partner.  Consequently, you may be making a good buck now, but you may not be able to make the same money in the future.  Put it away now in investments for retirement instead of taking that trip to Cancun or buying that Armani.

4.  The fourth reason why your extra cash should go to retirement ASAP is that assuming that you will have more free, investable cash in the future is probably not accurate.  I see so many associates put off investing because they see that their lockstep salary will go up in a few years and they think that they will have more money to invest then.  However, it just does not work out like that.  Here are some reasons why (this is not an all-inclusive list, just the first few that I came up with):
  1. Failure to consider the tax impact.  It looks like your salary is going to go up $10K for next year.  However, after taxes only $6K makes it to your check.
  2. Inflation - even if your lifestyle does not expand, it typically cost more to maintain it each year due to inflation.  Figure it will be at least 3%/year.  If you are making $160K, taking home about $125K after taxes, and living on about 100K (assuming $25K goes to loans), then that 3% inflation costs you $3K of the $6K raise.
  3. Lifestyle Creep - Most people experience lifestyle creep of a greater or lesser degree as their time in practice increases.  They start to buy the fancy car and nice place.  They start to eat out more, etc.
  4. Getting Married - It's going to take money to get the ring, have the ceremony and reception, get a bigger space for the two of you, etc.
  5. Having a Kid - Now one of the two income-earners may have to stay home (or pay for daycare) and the couple's investable income takes a BIG, BIG hit.  They are used to living on both incomes and typically try to keep up the same lifestyle.  How's this for scary - two married lawyers, each making about $250K.  They have a kid and one stays home with the kid.  Three years later, not only are they not saving, they have blown through all of their investments and have big credit card debt.  They tried to live the $500K/year lifestyle that they were accustomed to on $250K/year. 
  6. Parents Need Help - Associates usually aren't even thinking about this one, but it starts to happen a lot once you get to be around 40-45.  Sometimes the parents start breaking down - sometimes their minds get a little funny.  They start to need someone to look after them - getting to the store, taking care of the walk and lawn, house repairs, housecleaning (it sometimes get to be more than they can handle.)  Let's not even think about other costs.
  7. Kid's School Tuition - Another big expense.  College of course, but you may have to pay tuition for primary or high school, too.
Taking into account all of the above, you can see that even if your salary does go up, the increases are going to be substantially swallowed by taxes, inflation, lifestyle, and new expenses.  Every single person that I know that thought that they would have more money to invest in the future actually turned out to  be wrong.

Further, by putting aside the smaller amount right away (let's say $3600/year) you make it easier to succeed in the long run because you will only have to come up with $3600/year in the future, not $7200 or $14,400/year which would be far more difficult.

5.  (This might sound a little strange, but I have found that it often works with people who are buying toys instead of contributing to their retirement.)  The fifth reason why your extra cash should go to retirement ASAP is to that you can buy more toys, have more stuff and spend more money on yourself over the course of your life.

Going back to our example in #1, above, Associate A denied himself "toys" for 10 years (while contributing from 25-35), but now gets to spend $2000/year on toys for the next 30 years.  Conversely, Associate B bought himself $2000/year worth of toys for the first 10 years, but now does not get to buy those toys for the remaining 30 years.  Which would you rather have - 10 years without buying yourself toys or 30 years without buying yourself toys?  If you compare the direct spending, Associate A gets to spend $60,000 on toys while Associate B only gets to spend $20,000 on toys.  Wouldn't you rather have $60K to spend on toys as opposed to $20K?

Be greedy and get more toys over the course of your life by starting to invest right now.  By delaying your purchase, you can have a LOT more later.  You will also sleep better at night!

Good luck!


  1. I think that to be fair, you need to take inflation into account when you assume rates of return and amounts of investment.

    In terms of real dollars, saving $2000 at age 25 is very different from saving $2000 at age 50.

  2. And 8% in real returns strikes me as pretty unrealistic.

  3. For those looking for a discussion about nycsolo's questions, take a look at my subsequent post at