David R. Evanson
Privately Published, Spring, 2004
Can you imagine spending more than more than $380,000 for a car or $37,000 on a family vacation? Or $50,000 for a home theater system?
But this is exactly what many people do pay, and more when current spending is viewed in terms of its potential future value.
Take the example of a car. If a 30-year-old couple were to forego the purchase of a new $50,000 car and instead purchase more modest transportation for $24,000, the $26,000 that was saved could grow, assuming an annual 8% tax-deferred return, to $384,419 at the time of retirement at 65 or $103,897 by the time their newborn was ready to go to college in 18 years.
Likewise, when the couple takes a $2,500 winter getaway (following an annual summer vacation) instead of investing that money, that one vacation will mean they could have $36,963 less in total assets at retirement. When their daughter goes off to college, they could have $9,990 less to pay her expenses, or $17,121 less when she gets married in 25 years.
For people who have the opportunity to make pre-tax investments through payroll deductions, the prices for today’s consumption are even dearer in terms of future value. Assuming a 30% tax liability, the $2,500 of after-tax dollars required for that winter getaway is the equivalent to $3,571 pre-tax dollars, which if invested for 35 years in a tax deferred 401(k) account earning 8% annually, eventually would be worth $52,798. That’s an expensive getaway! Should you decide to forego a $2,500 vacation in each of 35 years and invested that money in a tax-deferred account, you could eventually have $615,417 to spend on your retirement, and travel.
How can this be? In a phrase: tax-deferred compounding. Over time, compound growth can make small amounts of dollars grow into successful investments that can support significant endeavors, such as sufficient retirement income. In other words, making small sacrifices now can enable you to avoid making large sacrifices later on in life.
Yes, we want to take vacations now, but those vacations have a future cost. This gets to the heart of the conflict that every individual investor faces — the trade off between current consumption and future savings. Unfortunately, these competing forces are exact opposites — one must come at the expense of the other.
The amount we earn sometimes obscures the truth about our spending. Even for high-income households, a great deal of our earnings are used to cover fixed expenses. Mortgages, car payments, insurance, taxes, food, among other expenses, consume a great deal of our overall income. The balance, or so called discretionary income, is what’s left. Since discretionary income is the source of our savings, this leads to another very important idea. Generating sufficient wealth for retirement or other obligations isn’t simply a matter of saving and investing. Spending is a big part of the picture too.
That fact is, even small changes in spending can have a dramatic impact on the wealth we create to meet future obligations.
For instance, taking your lunch to work, and saving $5.00 per day works out to about $1,250 per year. But, assuming a 8% return, $1,250 per year invested tax-deferred over 25 years adds up to $91,382, before taxes. Of course, making your lunch everyday is a drag, and it might not even be practical.
Here are some other seemingly small indulgences which could create significant wealth if they were channeled toward savings and put to work with the power of compounding behind them: Purchasing a commuter mug and making coffee at home instead of stopping for a $2.50 cup on the way to work adds up to $70,802 after 30 years of tax-deferred savings earning 8%. (Of course, brewing coffee at home costs money but at a much lower cost — 25 cents a cup. Over 30 years, you would be foregoing about $7,080 of future earnings.)
Stopping smoking not only improves your health it also can be quite lucrative. Putting the cost of a pack a day (about $120 a month, assuming a one-pack-a-day smoking habit at $4 a pack) into savings for the next 30 years might be worth $163,123, assuming a tax deferred 8% return.
Everyday pleasures and the occasional winter getaway are part of what makes life worth living. While you enjoy the pleasures of life, T. Rowe Price can help you manage your finances so you can accumulate saving more efficiently. For instance, our Automatic Asset Builder plan allows you to invest as little as $25 a month. With electronic funds transfer technology, this $25 can be deducted directly from your checking account on a day of the month that is convenient for you. The ability to invest small amounts of money on a regular basis with the minimal amount of effort enables you to take full advantage of making a small sacrifice and capitalizing on the power of years of compounding. With this powerful tool working for you, the small sacrifices you make today can help ensure that you don’t have to make big ones in the future.
All examples are for illustrative purposes only and not meant to represent the return of any security.
Dollar cost averaging involves continuous investment in securities regardless of fluctuating price levels, and you should consider your ability to continue purchases through periods of low price levels. Of course, this doesn’t assure a profit or protect against a loss in declining markets.