The concept of saving for retirement should not complicated. The basic idea is that, while you are young and able-bodied, you work and produce. You consume only part of what you produce and save the rest. When you are old and can no longer work, you begin consuming what you have saved.
The concepts of consumption, savings and retirement does not even have to involve money. It would apply to Robinson Crusoe living alone on a tropical island consuming coconuts and fish. It even applied in ancient times, before money, when a farmer produced grain only for himself.
Stockpiling Corn
Suppose you are one of those ancient farmer and produce 100 bushels of corn each year. Suppose further that each year you consume 80 bushels and save 20 bushels. If you work for 40 years you will have accumulated 800 bushels of corn in your silo. That is enough corn to last ten years if you continue to consume 80 bushels per year.
If you want your retirement to last longer, you have to consume less and save more while you are working. If you consume only 70 bushels and save 30 bushels, after 40 years you will have stockpiled 1,200 bushels of corn which will last for about 17 years.
Table 1 shows the number of years you can spend in retirement for various savings rates. If you save 50% of what you produce for 40 years, you can retire for 40 years. This should be obvious because you put in 50 bushels each year for the first 40 years and take out 50 bushels each year for the next 40 years.
| Consumed Per Year |
Saved Per Year |
Bushels Stockpiled |
Years in Retirement |
|---|---|---|---|
| 90 | 10 | 400 | 4.44 |
| 80 | 20 | 800 | 10.0 |
| 70 | 30 | 1,200 | 17.14 |
| 60 | 40 | 1,600 | 26.67 |
| 50 | 50 | 2,000 | 40.0 |
Stockpiling Gold
The chances are you are not a farmer and can’t stockpile corn. Like most people, you probably work for a living and get paid money. If money were still gold and silver coins, instead of stockpiling corn, you could be stockpiling gold and silver.
Of course no one gets paid in gold anymore. Everyone is paid in the local currency like dollars or Euros which are subject to inflation. A bushel of corn is a real commodity and will be the same bushel in ten years as it is today. (Assuming it doesn’t rot or go sour.) It does not lose value from inflation. But money loses value every year from inflation. So you could buy gold with your savings and stockpile gold, which should also keep up with inflation in the long run. But there may be better choices than stockpiling corn, gold and silver.
Stockpiling Something with a Real Rate of Return
Gold does not pay interest, so it has a zero rate of return. In fact, there is some cost to store it. So instead of stockpiling gold, you could buy inflation-indexed government bonds. Inflation-indexed means your bonds won’t lose value from inflation. If those inflation-indexed bonds had a zero percent real return, you would get the same results as in Table 1.
Now here is some good news: inflation-indexed government bonds pay interest each year and have a positive real rate of return. (Real rate of return means after inflation.)
Suppose that you were able to get a fixed 2% real rate of return from your inflation-indexed bonds. If you saved 20 dollars per year, after 40 years you will have accumulated $1,208.04, much more than the $800 with the zero rate of return you get with bushels of corn or gold coins. This will last about 24 years in retirement if you spend 80 dollars per year. That beats 10 years with zero return.
Table 2 shows the amount accumulated and the number of years you can retire for various savings rates with a 2% real return, assuming you earn $100 each year. Compare this with Table 1. You accumulate more and can retire longer with a 2% real rate of return than with zero return. That should be pretty obvious.
| Consumed Per Year |
Saved Per Year |
Amount Stockpiled |
Years in Retirement |
|---|---|---|---|
| $90 | $10 | $604 | 7 |
| $80 | $20 | $1,208 | 24 |
| $70 | $30 | $1,812 | 37 |
| $60 | $40 | $2,416 | 83 |
| $54.72 | $45.28 | $2,735.49 | forever - Critical Mass |
| $50 | $50 | $3,020 | forever - Above Critical Mass |
Critical Mass
Notice in the table that if you consumed $54.72 and saved $45.28 each year, with a 2% annual real return you will have accumulated $2,735.49 after 40 years. Then you could withdraw $54.72 per year forever because a 2% return on $2,735 is $54.72. When the withdraw equals the investment return, your stockpile remains constant every year. This is the definition of critical mass.
Above critical mass, your stockpile grows each year. Below critical mass you stockpile shrinks. The ideal place to be in retirement is at or above critical mass. This should be a goal to try and achieve. It is doable if you can save 40 or 50 percent of your income. The more you save, the faster you will achieve critical mass.
TIPS
Right now at the beginning of April 2010, 30-year U.S. Treasury Inflation Protected Securities offer a real return of about 2.2%. If someone retired today, they could put their entire stockpile into the 30-year TIPS and withdraw 2.2% per year and the balance will stay constant.
For instance, if you need $36,000 per year, when TIPS yield 2.2%, critical mass is $1,636,363. If TIPS were yielding 3%, critical mass would be $1.2 million. At 4% real yield, critical mass would be just $900,000.
I will have more to write about reaching critical mass in future articles.
The views expressed in this article are those of the author and do not necessarily represent the views of Laguna Beach Bikini, its editors, staff or any other organization.
