Investing to Beat Inflation!

Today I read an article over at Consumerism Commentary about How to Save a Million Dollars at Any Age. I noticed immediately, and so did several other readers, that $1 million isn't all its cracked up to be 30 or 40 years from now. Inflation is the nasty beast the keeps prices going up year after year. A seemingly tiny 3% annual inflation rate cuts the value of your investment by 326% in 40 years. However, by starting to save early we have one powerful tool to fight inflation, career growth!

It is important to realize that as you progress through your career (and as your salary grows with inflation) the amount you are able to save goes up drastically. Wages tend to increase at a rate that slightly beats the inflation rate. While we don't always get a raise every year, on the whole almost everyone grows their income over time. The trick to beating inflation in your retirement savings is to adjust what you save each year to keep up with inflation. You need to take at least half of any raise you get and use it to increase your retirement savings. For example, if you get a 4% raise, increase your 401(k) contribution by 2% until you get to at least 10% (my goal is 20%). Then once you reach your target rate, in successive years continue to increase the dollar amount so you maintain that percentage.

Example: Lets say you make $40k now at age 25 and save 6% of your salary. Each year during your career you get a 4% raise (matching the average growth of the economy long term). With the first seven raises of your career you bank half of it and keep the other half to spend. Here is what it would look like:

Salary	401(k) Contribution		Income After Saving		401(k) Balance
$40,000.00	$2,400.00		$37,600.00		$2,400.00
$41,600.00	$3,328.00		$38,272.00		$5,920.00
$43,264.00	$4,326.40		$38,937.60		$10,720.00
$44,994.56	$5,399.35		$39,595.21		$16,976.95
$46,794.34	$6,551.21		$40,243.13		$24,886.31
$48,666.12	$7,786.58		$40,879.54		$34,663.79
$50,612.76	$9,110.30		$41,502.46		$46,547.19
$52,637.27	$10,527.45		$42,109.82		$60,798.42
$54,742.76	$10,948.55		$43,794.21		$76,610.85

After doing this eight times you will be savings 20% of your income for retirement and be making $52,742. You will have lost some ground to inflation but not too much.

Here is the great part, if you keep your savings percentage the same over the rest of your 40 year career you will end up with over $3.24 million! Even adjusted for inflation this is roughly equal to $1,000,000 today. You never miss the money you saved either!

If you add into the mix a maxed out Roth IRA this is what your results would look like after 40 years:

Salary	401(k) Balance		Roth Balance
$192,040.83	$3,241,681.40		$1,403,905.20

Total Savings: $4,645,586.60

Income @ 4% Withdraw: $185,823.46

You can draw $185,823 each year in retirement and never touch the principle. This would be more than 96% of your $192,040 pre-retirement salary and equal to about $57,000 today adjusted for inflation.

As you can see, inflation does not have to ruin your hopes of retiring in comfort. Keep this in mind when you get your next raise and you feel the temptation to increase you lifestyle. Lifestyle creep is a far more ugly beast than inflation. Spending more than you make is the sure-fire way to a disappointing retirement.

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Millionaire Rule #7

Fund 401(k) to Get the Full Match
There is no better way to save for your financial future than to take advantage of a 401(k) which is matched by an employer. It is rare that I will state anything in the personal finance domain with this much certainty. An employer match is free money. No offense intended, but you would have to be an idiot to ignore FREE MONEY!

For those of you who have never heard of a 401(k) or don't really understand them I will give a quick primer. It is named after the section of the tax code which defines the rules of these accounts. A 401(k) is a savings account for the purpose of funding retirement. If you take money out before age 59 1/2 you will owe taxes and a 10% penalty to the IRS (DO NOT DO THIS). Money contributed is completely protected from taxes until you withdraw it. This tax benefit means that you can avoid taxes now. By avoiding taxes you will have more money to save, and each year your savings will continue to grow tax free until retirement.

A 401(k) account is set up by your employer, held at an independent financial services firm, and managed by YOU the investor. You choose how much goes into the account each pay check (call your HR department to set this up) and you pick your investments from a list of choices provided by the servicing firm. Lastly, and most importantly, many employers encourage employees to save by contributing money on the employee's behalf. This is called "matching" because it is normally arranged such that the employer will kick in a certain percentage of what the employee contributes. Common matching arrangements are 50% of every dollar up to a maximum of 3%; in this case an employee would contribute 6% of their gross pay and the employer would add an additional 3% (for a total of 9% of gross pay saved). Some employers are very generous and offer even more free money!

I will give a simple example to show the power of a 401(k). Lets consider Joe, a regular guy making $50,000 a year. Each year he will get a small raise of 3% and his investments return a moderate 8% per year. He is 30 years old and will work until he is 67 year old. The table below shows Joe's results depending on the type of investment account he uses.



I will say again, that not putting in the money necessary to get the full match is leaving free money on the table; don't do it. The best case shown in the table produced a nest egg of over $1.28 million which is roughly double what could have been saved in a taxable retirement account.

Now I realize that not every person has been lucky enough to find a job that offers a 401(k) and that a match is not offered in all 401(k) plans either. Do not loose hope! There are still other retirement saving options that are pretty good. If you want more information on your choices, continue reading the rest of my series Millionaire Rules.

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Inside My Portfolio

This blog is all about my path to wealth so it is about time I shared the full details of how I invest. In future posts I will add more information, but for now all you need to know is that I am working to have a fully diversified collection of index funds known as a lazy portfolio. Comments and questions are welcomed and encouraged. Subscribe to my RSS and check back to learn more about my investing philosophy which I think is my best opportunity to build wealth.

Personal Investment Employer Contribution Roth IRA $2,600 401(k) $6,176 $3,860 Holdings Ideal Allocation Current Allocation Description Roth IRA SWERX NA 5.26% Schwab Target 2040 401(k) VFINX 30% 31.20% Vanguard 500 Index VEXMX 10% 13.36% Vanguard Extended Market VFWIX 40% 37.55% Vanguard FTSE All-World ex-US VBMFX 5% 7.42% Vanguard Total Bond VSGBX 3% 5.20% Vanguard Short-Term Federal Other 12% 0% Emerging Markets, REIT, Gold, ...

A little explaination may be needed. First, my Schwab 2040 Fund is not a part of my ideal asset allocation strategy. It is a temporary account until I have built up enough money to meet the minimum account balances required for my REIT, Emerging Markets, and Commodities funds I want to hold at Vanguard. I selected Schwab for this because it was very friendly to those with small amounts to invest (no account fees, $100 to start, and $100 per contribution). Second, I do not exactly hold the Vanguard funds I list as my 401(k) holdings. The funds I actually hold are not open to the public but track the exact same index and have a similar expense ratio to the Vanguard funds. For all intents and purposes they perform identically. Also, my allocation is slightly off in my 401(k) because I am unable to directly buy my "ideal allocation" due to purchase minimums (and other logistical problems) so I have to move around my new money to move toward the right balance. Over time as the amount of my new contributions becomes a smaller percentage of the account balance I will move closer and closer to my ideal allocation. Finally, I would do an all out rebalance of my account if it strays more than 5% from my ideal (this has not happened yet due to how I use new money to do mini-reblancing bi-weekly).

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Back to the Grind

I am back from my Holiday travels. The entire trip consisted of three things: 1) Driving, 2) Eating, and 3) Football. My wife and I had a good time visiting her family, and I'd say the trip was a success.

During the trip I was asked several times what my plans are for the future. That got me thinking that I don't really have a cohesive plan for the next phase of my life. I've reached a point where most of my short term goals like completing my masters degree and buying a house have been achieved. What do I do next?

I might get a Ph.D. It can almost never hurt to get more education (especially when my work contributes to these endeavors) and it would be really neat to be Dr. Adfecto! I have also thought about becoming a Certified Financial Planner. Why not make my favorite hobby into my day job? I might actually enjoy my work that way. I have also looked into becoming an entrepreneur by starting businesses in a few different fields; 1) real estate investing, 2) real estate property management, 3) franchise (Subway, Papa Johns, etc), 4) home theater/networking/automation/AV installer, and 5) financial services firm. I can already see the glass ceiling above me at my current job (though I have a few years before I hit it) so I want to be prepared to maximize my earning potential.

Another thing I thought about a lot over the last few days is my near term financial goals. I'd like to put them down here to document my thoughts and outline the specifics. First, I want to pay off all of my debt except my mortgage. That is my most immediate goal and I think is a great goal that everyone should achieve. I currently have about a 12k car loan and about 12k in consumer debt that I want to pay off. I also want to reach a savings level that maxes my Roth IRA ($5500/year) and puts me on course to max my 401k (15% of gross pay). Next I want to purchase (preferably with cash) a replacement for my 1999 Chevy sedan that is sadly already struggling. Third, I want to establish an emergency fund with > 3 months of expenses in an online savings account. I have set a very ambitious completion date of July 1, 2010.

This is the basic advice that the columnists like Walter Updegrave (CNNMoney), Michelle Singletary (Washington Post), and Liz Pulliam Weston (MSN Money) or the gurus like Dave Ramsey (The Total Money Makeover), Robert Kiyosake (Rich Dad, Poor Dad), and David Bach (The Automatic Millionaire) or the scores of personal finance bloggers (Money Blog Network) write about every day. I agree with them and will put these goals into practice in my life. Reading these articles and books is a great start however, is not enough to bring out the type of wealth I want in my life. I want to be able to travel to exotic places, to own a beautiful spacious home (or two) with upgrades like a home theater and billiards room, own a pair of late model mid-luxury cars (for example Infinity G35 for me and an FX35 for my wife). I want be able to work with flexibility and generate as much of my money as possible from completely passive sources (bonds, stocks, 3rd party managed real estate or businesses, etc). In other words, I want to be truly wealthy with a net worth of 10-15 million. That my friends is not the 'Millionaire Next Door' or the 'Comfortable Retiree' that will result from the advice of those I mention before. What then should I do to achieve this kind of wealth that such a small percent of Americans achieve? That is a whole different set of ambitious goals I need to figure out.

Aspire 2 Wealth is a center piece of this thinking. It will provide me a place to put my thoughts into concrete form so my ideas don't go to waste. It will also (hopefully, one day soon) give me an audience (or even better, a community) to give me feedback, encouragement, and tough love to push me further toward my goals. I think I need someone to call me on my pie-in-the-sky dreams and make me take action on the dozens of "million dollar ideas" I think I have on a regular basis. Thoughts and suggestions appreciated.

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