海角大神

Retirement contributions: When should they delay debt repayment?

Retirement contributions, especially if your employer is matching them, can be tempting to make. But how can you decide whether saving for retirement should take priority over paying off loans?

A few weeks ago, I put out a call and for detailed posts that people would like to see. I got enough great responses that I鈥檓 going to fill the entire month of July 鈥� one post per day 鈥� addressing these ideas.

On Facebook, Tyler wanted to know, 鈥淪hould I stop my retirement contributions while i pay back my college loans? I am 23 and my employer will match up to 5% of my contribution. Should i continue? or hold off until my loans are paid?鈥�

The challenge with any question like this is that it relies so much on future events. What will the stock market do over the next thirty or forty years? That鈥檚 unknown. What path will Tyler鈥檚 life take over the next ten years or so? That鈥檚 unknown as well. Both of these factor enormously into answering the question above.

The best thing we can do is follow some reasonable approximations and rules of thumb for future investment growth while also striving to give Tyler as much freedom as possible in the coming years.

The Ghost of Investing Future

In order to get an estimate of how much someone should be investing for retirement, you have to come up with a few basic assumptions.

When will the person retire? This lets us know how many years of investing we鈥檒l be able to account for. I鈥檒l asume that Tyler will retire at 75, giving us 52 (!) years to work with.

How much of an annual raise can we assume? I usually just match this at the same rate as inflation. Speaking of inflation鈥�

How much inflation should we assume? I usually peg this at 3%, which is pretty sound based on the economy of the last twenty five years.

How much of an annual return on stocks can we assume? Warren Buffett projects a 7% annual return over the long haul in the American stock market, so I鈥檒l use that number.

Do you see how tenuous all of these calculations are? When you estimate retirement savings, you鈥檙e making a lot of guesses for the future.

What you鈥檙e going to shoot for is an amount high enough so that the person鈥檚 annual expenses equal 4% of the total savings at the time of retirement.

I ran the numbers, assuming that Tyler is able to live on about 75% of his salary each year. My calculations showed that Tyler should be saving somewhere between 9% and 10% of his annual income for retirement, so we鈥檒l use 10%.

10% is an excellent thumbnail to use. In this case, Tyler has the advantage of a long period until retirement, but I鈥檓 also using some pretty conservative returns on his investments for my calculations.

Tyler鈥檚 Choice Today

In order to make it to a healthy retirement, Tyler needs to be saving 10% of his annual income starting today. He can choose to delay it a few years, but then he鈥檒l be locking down 11% or 12% or more to make it to his goals. He鈥檚 a lot better off locking things down at 10% starting today.

Tyler鈥檚 employer will match up to 5% of his contribution, so if Tyler contributes just 5% of his salary today, he鈥檒l be on pace for what he needs for retirement. This is exactly what I would recommend that Tyler does.

Once that鈥檚 taken care of, he should throw every dime that he can at his debts. It is far easier to live a little lean now when you鈥檙e single and aren鈥檛 weighted down with responsibilities than to live lean later on when you鈥檙e burdened with career and personal requirements.

Should Debts Ever Delay Retirement Contributions?

This is a tricky one to answer. Quite often, people eschew retirement savings in order to pay off debts because they don鈥檛 want to make lifestyle changes. This is a giant mistake. If you find that you鈥檙e in a situation where you can鈥檛 make your minimum debt payments, a small retirement contribution, and live your current lifestyle all at once, changes need to be made with regards to your lifestyle first and foremost.

If you are in a situation where further lifestyle changes genuinely are not possible 鈥� meaning you have no cable or satellite bill, no cell phone, no new or nearly-new car, no living quarters larger than you need, etc. 鈥� then you should take care of your high-interest debts before renewing your retirement savings. Of course, this does need to be coupled with an emergency fund and a commitment to avoid debt in the future, because without that, this is all a moot point.

Personal finance almost always comes back to impulse control, and this is no different. If you can鈥檛 control your impulses and desires when it comes to spending money, financial success will almost always be elusive in your life. You won鈥檛 get ahead if you can鈥檛 control yourself.

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