The Real Reason to Start Saving When You’re Young

It’s a good idea to start saving when you’re young, but not for the reasons that personal finance experts give.  They offer tidy examples that have little connection to the real world.  Here’s a typical version:

If you save $1000 per month from age 25 to 35 and then save no more, at a 7% annual return, your savings will grow to $1.3 million by the time you’re 65.  If instead you wait until you’re 35 to start saving $1000 per month, and you save for the full three decades until you’re 65, you’ll only have $1.17 million.  That first decade of saving is more valuable than the last three decades combined.  So get started early.

This seems reasonable until we test it on someone who is 65 years old today.  Meet Jim.  Back in 1985, he was 25 years old working full time.  The minimum wage at the time was about $700 per month, but Jim was doing well making $1200 per month.  Now let’s ask young Jim to start saving $1000 per month.  Hmm.  That didn’t go well.  He says he can barely afford to save $100 per month.

But coming back to today, Jim is retiring with $2 million saved.  How did he do it?  The answer is that there was inflation and he got lots of raises in 40 years.  He was able to save larger amounts in later years to make up for what he couldn’t save when he was young.

The problem

The examples that many personal finance experts give make no sense because they assume that people will save the same dollar amount every month for decades.  This makes no sense.  Inflation compounds over the decades, and average wages rise a little faster.  

But there is another effect at play as well.  The typical 50-year old makes more than the typical 25-year old.  Jim’s pay rose by more than the average wage inflation from age 25 to his 50s.  He had much greater capacity for saving later in his career than he did early on.

My case

From the time I started working full time until I retired, my income rose by a compound average of 8.5% per year, or about 6.1% above inflation.  This is a faster rise than we can expect from an investment portfolio.  Let’s assume that I saved 10% of my income every year.  The first year’s savings would have grown in my portfolio for decades.  But it would still have been smaller than the 10% I saved in my last year working.  In my case, my later years of savings were more important than my early years of savings.

My case is not typical, but for most people, the amounts they’re able to save when young aren’t much more valuable than the amounts they can save late in their careers, even after we account for decades of compounding.

The real reason to save when young

The real benefit of saving when you’re young has little to do with investment compounding.  Having some money saved protects you against financial calamities and it gives you choices.  It’s hard to plan for the future if every car repair has you begging family and friends for money.  It’s hard to quit a terrible job if you won’t be able to buy food.  Even a small cash buffer can make a big difference.

For those young people lucky enough to have large incomes, saving big amounts and letting them compound is a great idea.  But for everyone else, don’t feel guilty about not saving huge amounts.  Focus on building enough of a cash buffer to ease your life.  Increase this saving rate over time as you’re able.  Don’t let personal finance experts make you believe all is lost if you haven’t saved large amounts before age 35.