Retirement Planning: Rule of 72
Very few rules of mathematics benefit the individual as much as the rule of 72. This rule states that if you can estimate your rate of return on an investment or your portfolio, you divide that number into 72 and it tells you how long it will take for that investment to double. For example, if you estimate an 8% return for the stock market, not an unreasonable estimate, divide that into 72 and it tells you your money will double in 9 years. We can use that number to predict what our present portfolio will be worth at age 66 (at the time of social security eligibility for many baby boomers), and we can work backward from a retirement goal to see if we are on track.
Example #1 - Say for instance that a 30 year old has $10,000 in his or her IRA. He has invested it in the stock market and wants to know what he'll have at age 66. He estimates an 8% stock market return for the next 36 years.
He will have $20,000 at age 39.
He will have $40,000 at age 48.
He will have $80,000 at age 57.
He will have $160,000 at age 66.
A 16:1 return! Not bad, but it gets better. If a 21 year old put the same $10,000 away he or she gets an extra double with an estimated 8% return so the balance at 66 would be $320,000. The key is to start early and use the government's gift to young people, the Roth IRA, which we will discuss in a future column.
Example #2- This time we will work backward. Most financial advisors recommend not withdrawing more than 4% from your retirement kitty in the first year. This means that if you want a $40,000 annual income in your first year of retirement (not including Social Security) you need to have saved $1,000,000. Sounds fantastic but it takes a lot of money to produce income at 4%. We already know we have to start early and use the wonder of compounding to produce most of the money. The individual wants to know how much money he or she needs at 21 or 30 to be on track with an 8% yield.
She estimates she will have 1,000,000 at 66 (her target).
She will need $500,000 at 57.
She will need $250,000 at 48.
She will need $125,000 at 39.
She will need $67.500 at 30.
She will need $33,750 at 21.
So at any age, if you know your retirement goal, you can estimate whether you are on track. The key is to take advantage of compounding as soon as possible. If you are completing your education that may be difficult(compounding works against you when you have a loan). But if you can get some money away and invest it wisely you will be much better off in the long run. The rule of 72 will guide you through your whole life of financial planning.