Posted by Gary Abely, CFP®, AIF®, CPA
If you read current headlines about Millennials you might draw some poor conclusions. For example, recently I was listening to The Clark Howard Show and heard Millennials spend more on coffee than their retirement savings. While I’m sure this may be true for some in their 20’s and early 30’s, it was a statement with a pretty broad stroke. For those Millennials truly doing this I have some advice: Costco sells Starbucks – buy a membership, it’s cheaper.
I was delighted to learn of an American Enterprise Institute study which concluded Millennials are better at saving for retirement then Gen X or Baby Boomers. Regardless of who saves more, there are common mistakes that are made by every generation. Some life lessons are learned the hard way. Here are a few mistakes commonly made. If you can avoid these, you will save plenty of headaches down the road.
Student Debt Payments
No, there is nothing wrong with investing for one’s future. Education is arguably one of the best investments one can make in themselves. This debt, however, often clouds our judgement in prioritizing our future savings. For example, I have met plenty of young workers who do not participate in their company’s 401(k) plan, instead focusing on student debt payments. While it is obviously important to pay off debt, especially high interest debt, it is more important to save when your savings are matched by your employer. Also, you should not paydown (other than required minimum payments) student debt until you have an emergency fund of three to six months of your spending needs. https://studentaid.ed.gov/sa/repay-loans/ is an excellent website which explains most student debt repayment options, even debt forgiveness possibilities. If you are confused, sit down with a financial planner to make sure your repayment plan is the most dollar savvy.
With the stock market reaching new heights, recommending a high allocation to equity investments (stock mutual funds) might seem like bad advice. The very fact, however, that the stock market has reached new all-time highs, is evidence that every prior decline in a diversified basket of small, medium or large stock mutual funds was only a temporary decline. Simply put, stock mutual fund investments, over periods of time, outperform almost all other asset classes. In fact, when I meet with Millennials and explain that the best thing for their future is another prolonged bear market early in their working years, I get some strange looks. Most people do not like to see their investments trading at a price less than they paid. However, if you are purchasing that same investment each month (in a process known as dollar cost averaging, or DCA), you are purchasing more shares. DCA is something an investor does when he or she participates in an employer sponsored retirement plan, such as a 401(k) plan, where you save each pay period. Saving a bit from each paycheck will ensure an averaging of prices, some high and some low.
Not recognizing that millennials have the best investment advantage of most other investors: TIME
While time value of money is often taught to accounting and finance majors in college, most students graduate without understanding the huge advantage time creates when investing. Time permits an investor the option to invest aggressively when young and to take advantage of compounding of investment returns. A general rule of thumb often used by planners suggests an investor might start off with an equity (stock mutual fund) allocation of 110 less your age. In other words, a 20-year old, may wish to start with at least 90% allocation to stock mutual funds and only 10% to less volatile bond funds. Of course, what asset allocation you choose also depends upon your personal risk tolerance. Volatility, while unnerving at times, is your friend as it produces lower prices wherein you accumulate (through DCA) more shares. Eventually, share prices will recover and you will have earned a higher rate of return. To illustrate the advantage of time, assuming a 9% rate of return, a 20-year old need only save $250/mo. to accumulate $1 million by retirement. Someone beginning at age 45, however, will need to save $1630/mo.
Taking from your future
One of the biggest mistakes millennials and other investors make is early withdrawals from retirement accounts for non-essential needs, without understanding long-term impact. Once, I had a 30-year old client who requested $5,000 from his 401(k) account to purchase new appliances for a kitchen remodeling project. Upon further questioning, he needed to net $5,000 and I also learned the existing appliances were in working condition. I calculated my client would need to take out $8,333 from his account to net the $5,000 after federal taxes and 10% tax penalty for pre 59 ½ age withdrawal. He responded, “Yikes”. He still requested the distribution. I then calculated that this $8,333 would grow to $123,000 (8% growth rate assumed) at age 65 and provide he and his wife a potential income stream of $232,000 over an assumed 20-year retirement span. This additional information was enough to squash the bad idea. He and his wife saved outside of their retirement account until they could save up enough money to pay cash for the appliances. A similar mistake is made by individuals when they work for a company for a brief time and decide to cash in the “small” vested retirement account balance vs. the paperwork required to roll these funds into an IRA (individual retirement account). The example above illustrates how small amount of money can provide plenty of income when left alone to grow.
Much of what we learn about saving and investing, we learn from our parents. Millennials have undoubtedly heard their parents discuss their “201K” at work after stocks declined by roughly half in the dotcom bubble of early 2000’s. Shortly thereafter, they likely heard about the “financial meltdown” and corresponding 57% drop in the stock market for the period ended March 2009. It is no wonder, therefore, that about one-third of millennials are apprehensive about investing in either a home or the stock market. With knowledge, millennials can avoid their parent’s mistakes by understanding the need to start saving early in life, and understanding risk and volatility is your friend not enemy when dollar cost averaging. Finally, managing debt appropriately and never stealing from your future for current non-emergency needs are also key life lessons to avoid costly mistakes.
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