Famed economist John Maynard Keynes popularized the term "paradox of thrift" referring to the fact that the more people save, the slower the economy grows because everyone is saving. While there is some debate as to whether or not this theory holds true, the point is that while it may make sense for us to save more individually while the economy is slow, if we all saved more, it would likely do the economy more harm than good. It turns out that I have found a similar paradox in saving for retirement. The truth is:
The more you earn, the more you have to save for retirement.
You must be thinking, "What?!?! I thought that doing well when I was young gave me the opportunity to spend more now and save later!"
OR
"Who cares about retirement? It is 30 years in the future! I am worried about taking care of my children and saving for college."
There are so many factors involved in the calculations, but the facts are the same in almost all scenarios. As you earn more, in order to maintain your standard of living in retirement, you must save a greater percentage of your income. There are many reasons for this.
First, we have no idea where our lives will lead us. We may earn more as we get older or we may earn less. Second, you can borrow for college, but you cannot borrow for retirement. This is why so many advisors suggest saving as much money as you can in retirement plans like IRAs or 401(k)s as soon as you can. It then has the power to grow and work for you when you are ready to retire. Thanks to the power of compounding, $5,000 when you are 25 with a 7% growth rate, will become about $80,000 at age 65. Waiting until later in life takes away from this growth potential--so if your income increases as you get more experience, you must save a greater percentage of that income to have the same money to spend later. Finally, market volatility can change your likelihood of reaching goals. The longer you have, the more likely you are to reach your financial goals despite market volatility. The longer you wait, the more you will need to save.
This blog might scare you, but it shouldn't. However, it should teach you something, and it is nothing different than you have heard before. If you have not started saving, start saving yesterday. Save as much as you can. Don't let company matches in retirement plans go by. It's free money. Secondarily, if you hit a windfall or sudden increase in earnings, think hard before drastically increasing your spending.
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