Advice for your Grandkids

05/13/2014 9:00 am EST

Focus: STRATEGIES

Robert Carlson

Editor, Retirement Watch

The best thing you can do to ensure the financial security of your grandkids isn't to give them money or wealth, though that would be helpful. Sound advice is what the younger generations need, suggests Bob Carlson, money management expert and editor of Retirement Watch.

The population following the Baby Boomers is in bad financial shape, according to research by Pew Charitable Trusts. The first half of the Baby Boom generation looks to be the last group to retire with enough income and assets to maintain their lifestyles.

A key problem for those following the Boomers is that they are accumulating debt at a faster rate than their predecessors. More importantly, younger generations aren't saving nearly enough money for the future.

They lag behind previous generations in accumulating savings in their early years. That's doubly bad, because the post-Baby Boom generations likely will need to save money at a greater rate than previous generations.

The Baby Boomers benefited from the post-World War II global boom and extended bull markets in both stocks and bonds. The housing bull market, that lasted decades, also helped the balance sheets of the Boomers.

The younger generations can't count on similar bull markets to offset low savings rates and high debt levels.

Saving money is vitally important to financial independence. In fact, other recent research indicates that savings rates are more important to financial security than earning high investment returns or a high income.

Financial security requires a higher savings rate than many people realize. To have a high probability of saving enough to withstand most investment environments, young workers should save 16.62% of their salary for 30 years, according to research by economist Wade Pfau. He refers to this as the safe savings rate.

The optimum savings rate for someone can be determined only after the fact, knowing the investment environments during both the accumulation, and the spending years, as well as the investment choices made by an individual.

Pfau's goal was to determine the savings rate that would provide security over most investment environments.

Pfau ran numbers for a number of different environments and several investment strategies. The optimum savings rate varied widely, but the 16.62% consistently provided enough money for retirement under the most circumstances.

Of course, the longer one waits to save, the higher the savings rate has to be. Pfau assumed a person saved for 30 years in order to have money to spend for, at least, 30 years.

If someone waits to begin saving and saves for only 20 years, the safe savings rate jumps to over 30%. But beginning to save early, and delaying retirement so that the savings period is 40 years, reduces the safe savings rate to 8.77%.

Perhaps more importantly, a long, steady period of saving reduces the importance of investment markets in the years just before and after the retirement starting date.

When people wait to save and accumulate just enough to meet their retirement goals, their financial security is very dependent on investment performance in the ten years before retirement begins and the first ten years of retirement.

They depend on the last few years of investment performance before retirement to compound their modest nest egg into one that is big enough to sustain their retirement. That's a big risk and can be reduced by saving more money earlier.

Also, the earlier you begin saving the more work the investment markets do for you. Consider the “70% rule." Suppose a young person decides to save $3,000 annually for all his working years and earns 6% annually on that money.

After 34 years of saving, investment returns will comprise over 70% of his retirement nest egg, while his contributions are less than 30%.

Start saving early, and the markets will do most of the work for you through compounding. But wait to save, and sacrificing current consumption in those later years will bear most of the burden.

Your contributions will make up a much higher percentage of the nest egg and, in many cases, will dwarf the contribution of market returns.

Young savers also shouldn't try to earn the highest investment returns or seek the hottest investments. That's playing the lottery with your retirement savings.

Instead, begin your savings plan with a balanced fund such as PIMCO All Asset All Authority (PAUAX:US), MainStay Marketfield (MFLDX:US), or Vanguard Wellington (VWELX:US). It's important always to have a balanced portfolio so you earn steady solid returns and have a margin of safety for your financial security.

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