The world of pensions and retirement finance is a complex one and if you feel daunted by it, you are not alone! It can seem easier to defer any decisions until that non-existent day when you ‘have time to look into it properly’. But by engaging with it now, not only can you place your investments wisely but you can even aim to retire a millionaire! Just follow my tried and tested methods for investment success…
Invite to London book launch party June 22 https://t.co/nLsdzYDo6h
— Lars Kroijer (@larskroijer) June 7, 2017
Get rich quick?
Other than the silly ‘get rich quick’ schemes promoted by fraudsters and charlatans, most financial advisors will tell you that the amount of money you retire with depends on how much money you put aside, how long you put money aside for, what return you generated on your savings, and what taxes and other costs you incurred. No magic there.
Right, but what does that mean for me?
How much you can contribute obviously depends on your circumstances, but we can work backwards and figure out how much you need to be a millionaire. Let’s say you expect to contribute a fixed amount every year (in reality most people can contribute more over their working life) until retirement. Let’s also say we mean a millionaire in today’s money, and not future money where a million may mean a lot less than it does today because of inflation.
Warren Buffett has said that compounding interest is the most powerful force behind his wealth and Albert Einstein called it the most powerful force in the universe. Compounding returns many years into the future can lead to massive amounts, often far more than our intuition tells us. While we may put ‘small-ish’ amounts aside every year, compounding will turn our modest contributions into impressive sums.
To illustrate this point I made a short video on YouTube about how an 18-year-old who gives up smoking and puts the money into the equity markets can reasonably expect to retire a millionaire from the savings on the smokes alone (the same logic clearly applies to all kinds of savings). You can see the video here:
Similarly, let’s say you could put aside £6,000 every year between the ages of 23 and 67, and that you put all that money into the equity markets. Equity markets are obviously hugely risky and you need to be able to handle that, but they have also generated a very attractive compounding interest of 5% after inflation every year. What would you end up with? Just over £1 million (ignore tax), and you would retire a millionaire. How much would you need to put aside each year for 20 years with same assumptions to get to a million? About £67,000.
Not quite, unfortunately. Equity markets carry huge risks and while it is a reasonable assumption that they will yield 5% compounding return, there are no guarantees. It could be far more or far less.
If you want to be more certain of retiring a millionaire you could combine your equity investment with a lower risk/return one in government bonds or cash, but to attain the millionaire status you would need to put greater amounts aside. There is no free lunch.
— Lars Kroijer (@larskroijer) May 28, 2017
Build your own solution
While there are endless online calculators and software solutions available, it may actually be more instructive to build a simple spreadsheet yourself that is tailored to your circumstances. Appreciating that someone who does not have decades of background in finance may find the task daunting I did another YouTube video where I help you build a personal financial spreadsheet from scratch (watch the first video in the series here
You can make your annual input or the age you start at anything you like and see how things turn out. What if you don’t need a million, but instead £10,000 per year in retirement? How much will you be left with if you put aside £1,000 a year in equities? What about £2,000? What if equities compound not at 3%, but at 6%? What if you don’t want to put it all in equities, but in lower risk asset? How would that impact your expected outcome? But those are actually pretty random assumptions that in any case can be changed by simply entering a new number in the model.
We can keep adding complexity to the model, and by working through the spreadsheet you will naturally be asking a lot of the right questions. As an example, we may want to understand how the risk of the equity markets will impact the range of outcomes we can expect from a long-term exposure to those markets. Answering that question involves questioning what standard deviation to use, if you can even really use the standard deviation, fat tails, and so on. Sometimes there are no easy answers, but you will typically be far better off having thought of these issues than ignoring them.
Don’t be overwhelmed
At the end of the day I think there is a big advantage to appreciating how simple a lot of the financial software packages really are. I believe that when we are done with the spreadsheet you’ll understand more about your risk and what you can expect in the future than you would by studying the outputs page from an online broker, or a summary sheet from a financial planner. This will serve you well and could put you on the path to the millionaire status.
The good thing is that what you should invest in is probably much easier to answer. Since it is overwhelmingly unlikely that you are able to outperform the stock market yourself, or pick the one out of ten investment fund that can do so for you over a ten year period, you should simply buy the broadest and cheapest equity index tracker you can get your hands on. I suggest the world equity index tracker, perhaps from Vanguard. That will most likely leave you more money in the long run. If you want less risk than the equity markets, as many should, you could combine this with an investment in low risk government bonds or cash. Job done. If you want to see a video to outline this argument check out this one here:
Get rich slowly
So there are no hot tips here for immediate gains, but generating retirement funds is by definition a slow-burn. As a guide to long-term investment and return, these methods work. Just ask Warren Buffett and Albert Einstein.
Lars Kroijer is the author of Investing Demystified from Financial Times Publishing. He founded and ran Holte Capital, a London-based hedge fund, in 2002. You can follow him on @larskroijer.