In a recent article, I made a bold statement. Readers completely ignored it. In the article, I stated:
“The reality is that it is completely achievable for the majority of households to build a net worth of $1,000,000 or more over the course of a working lifetime.”
If it’s so simple and obvious that nobody argued the point, then why doesn’t everybody do it?
The reality is that while it is actually very simple, it isn’t easy.
A recent study by Vanguard, How America Saves 2016, looked at savings in 401(k) retirement accounts in America. There were some interesting findings. While the average 401(k) balance in the US was $96,288, the median was much lower at $26,405. What does it mean when the average, or mean, is much higher than the median? It means that some people are doing really well, while most people are not. Those doing well pull the average value higher, away from the median.
This is the kind of data analysis that is usually used to support anti-inequality campaigns. As expected, the Time article goes on to demonstrate that people with higher incomes have higher average and median balances. This is to be expected: Income and wealth are correlated. But what is overlooked in the analysis is that the discrepancy between the average and median balances is not only significant, it is also spread across all of the income ranges.
So, while people with higher incomes will tend to end up with higher balances, nevertheless every income level has a percentage of people who do a great job of investing for the future — and many who do not. It is not just a function of income; those on low incomes can build up a worthy nest egg. What the data suggests is that, given your income, you can personally have a huge impact on your financial future.
Related: 4 Retirement Account Horror Stories That’ll Keep Investors Up at Night
Obviously, a retirement savings plan like the 401(k) in the United States is not the only approach to wealth-building. Net worth can be built through equity in your own home, businesses, and, of course, rental property. Savings and other valuables will also contribute. Interestingly, many business owners and real estate investors will forego contributions to retirement savings plans in favor of a more “all-in” approach. Yet, as of 2013, less than 10% of American households had a net worth of $1,000,000 or more. Why is it so hard?
In this article, I first want to demonstrate that attaining a net worth of $1M is possible even on a low income by walking through an example. Then I want to consider some of the challenges that people face, especially at lower income levels. Finally, I will consider some of the opportunities that this knowledge opens up.
Pay Yourself First
In the classic book The Richest Man in Babylon, author George S. Clason exposes this timeless and foundational principle of wealth building: Pay yourself first.
The principle is that, no matter how much you make, if you take a portion of your earnings and set them aside for investment — never touching them for your day-to-day living expenses — then you will eventually wind up wealthy. Clason’s recommendation is to set aside at least 10%, living on no more than 90% of your income.
Now, BiggerPockets is a website about real estate investing. However, to keep things very simple, and to drive home the point, I am going to use the very accessible example of simply using a standard retirement fund investment to achieve the goal.
In this scenario, Amelia is the sole income earner for her household. She begins with nothing saved for retirement at the age of 25. Contributing regularly and consistently to her generic retirement fund for 40 years, she eventually retires at the age of 65.
The retirement fund for our example is very generic. It is not modeled on anything specific such as a 401(k). However, it does ignore taxes and fees; the percentages discussed would need to represent the net return.
Amelia starts at the age of 25 with an annual salary of $30,000. This puts her household income just below the 29th percentile in 2014 numbers. In making the claim that “the majority of households” can achieve a million-dollar net worth by retirement, I must at least show that more than 50% of households can do it. This example suggests that it is available to about 70% of households at face value.
I assume that Amelia works hard and benefits from a modest annual pay increase, at least partially offsetting inflation. The model applies a 2% increase to Amelia’s salary each year for 40 years. Long-term average inflation in the United States is 3.22%; since 1990 the number is between 2.5-3.0%. Giving Amelia a 2% raise each year is slightly under inflation and therefore relatively conservative.
As a result, in Amelia’s final year in the work force, just prior to retirement, she earns $64,942.34. This would put Amelia’s household at about the 55th percentile for income. So, while Amelia has had an increase over time, she has never earned “great money.”
For the purposes of our scenario, Amelia has read The Richest Man in Babylon but doesn’t have a lot of money, so she decides to set aside exactly 10% of her gross income for investment. She never increases that percentage.
Amelia invests in an S&P 500 index fund. Some sources will quote that the S&P 500 has averaged around 12% per annum since its inception in 1970. While this may be true, real world markets do not provide a smooth return. In fact, the S&P 500 has fluctuated wildly from year to year. In the chart below, you can see the results of investing in the S&P 500 from 1976 through 2015 inclusive, following the same scenario. This represents the most recent 40-year period available at the time of writing. As the chart demonstrates, the investment returns very closely mirror a smooth 8% annual return. The example uses 8% as a reasonable long-term expectation.
Meet Amelia, the Millionaire
So, is Amelia successful?
The chart below demonstrates the cumulative value of Amelia’s retirement fund over her 40-year working career.
As you can see from the chart, over time, the S&P 500 has tended toward very similar results to an 8% annualized return. It is absolutely true that there are fluctuations, so there would have been better and worse times to retire. However, both result in a retirement account balance of just over $1,000,000.
If it was so easy for Amelia, why doesn’t everybody do it? To quote Jim Rohn: “Because it’s easy not to do.” But let’s take a look at some of the specific challenges that people face while trying to achieve financial goals.
Cost of Living
The lower the initial salary, the more difficult it is going to feel to set aside 10% of income. Everybody has basic living costs that will take up the bulk of the earnings. Most tax systems account for this with a graduated or progressive income tax. In other words, people are charged less tax on the first several thousand dollars earned. That’s because this money is essential to meeting basic needs.
Using 2016 U.S. federal tax rates, if Amelia earns $30,000, she will pay $4,036.25 in federal income tax, leaving $25,963.75 per year or $2,163.65 per month to live on. If Amelia sets aside $3,000 per year (10% of gross income) for investments, this will reduce her monthly budget to $1,913.65. She will be acutely aware of that $150 per month which would really help her family’s lifestyle. (Depending where you live, there may also be state/local taxes).
Thus, Amelia will find it harder to set aside 10% of her income for investment than someone who earns $100,000 annually. However, it is also true that the majority of people expand their lifestyle to match their income — and therefore find it difficult to reduce their expenses to free up 10% of their income for investing. While it will be harder with lower income, most people will find it difficult unless they start very early establishing good habits.
That $30,000 will buy you a very different lifestyle in different parts of the country or around the world. In particular, cities are notoriously more expensive, and accommodation alone could consume a very large percentage of that budget. Living in an expensive city puts further pressure on Amelia to spend a higher percentage — maybe even every penny — of her income every month.
Does Amelia lack the will to stick to the plan? Do you? It gets especially difficult when big “unexpected” expenses pop up out of the blue. This is the main reason that, while it’s simple to become a millionaire on paper, the difficulty lies in the execution. It is easy to justify anything to ourselves, but if you are not working toward your goal consistently, it will become more difficult to achieve over time.
Lack of Control
For many investments, you have no control over the returns. Generally, the greater the expected return, the greater volatility there is. For example, you can probably get a fixed term investment with your bank for 3.5-4.0%. This return is very reliable. But it’s also well below the long-term returns you can expect from other investment classes. Meanwhile, investing in an S&P 500 index fund, your investment could lose 20% of its value or more in a single year.
The above example assumes that you actually have 40 years available to you before you want to retire and start cashing in on your investments. If you are older and have less time to retirement, then you will need to contribute more. This will either mean a greater percentage or if you happen to earn a higher income than our example, then at least more dollars. The same applies if you want to retire young and live off of your investments. It’s important to note that many government-controlled retirement plans like 401(k) have restrictions on when you can draw down the funds. Most of these are at or around a government-determined retirement age; generally, this is around age 65 but may increase over time as expected life spans increase.
Now that we’ve seen Amelia — who started with a salary of $30,000 per year and only got modest increases throughout her life — retire as a millionaire, let’s consider some ways in which your situation and choices may give you some advantages that Amelia didn’t have.
First, it’s important that you begin investing immediately. This is the one thing that Amelia did well, and look where it got her. Take charge of your finances, get on a budget, and start paying yourself first. Put aside at least 10% of your income for investments. It’s pretty clear that if you don’t invest anything for the future, in the future you won’t have anything. You can contribute to a retirement fund as described above, or you can look for more lucrative investments.
Learn about money and investing. What options are available? How does it work? What are the risks? What are the expected rewards? BiggerPockets is a fantastic place to learn about real estate investing as one option for your future. For example, if you learn how to invest in real estate using time tested and proven methods, you should be able to significantly outperform Amelia.
If you are not earning enough, take charge of your situation. What can you do to get a promotion? What about starting a small business on the side to earn extra income? If you are earning more than our example, then run your own numbers and see what you have available to you.
If Amelia’s starting salary had been $50,000 per year rather than $30,000 per year, then she would have retired with more than $1.8M.
Play Great Defense
If you are on a low income, you can still achieve impressive results financially. But you will need to play excellent defense (i.e. budgeting and investing consistently) to meet long-term financial goals.
Related: The Average Retirement Account Has Less Than $100k: Here’s How Real Estate Can Help
If Amelia had set aside 15% of her gross income instead of 10%, she would have retired with more than $1.6M. This may not have been easy for Amelia, but what about you?
Take advantage of opportunities, such as company matching contributions, if they are available to you. Find out about tax breaks or advantages of any retirement plans available in your area. (Different countries have very different plans available, so it’s important to get localized information on this.)
If Amelia’s company matched her contributions up to 5% of her gross income, that would have been the same as if she’d contributed 15% herself. This means that she would have retired with more than $1.6M. She would have gained more than $500,000 in bonus money from her employer!
If you are young, time is on your side. But only if you take action. The longer you wait, the more time will shift its loyalties and begin to work against you.
Now, imagine if Amelia had combined all of these options. What if Amelia worked hard in school and landed a great job with a starting salary of $50,000, contributed 15% of her gross income, received a match of 5% from her employer and started investing at age 25? Amelia would have retired with more than $3.6 million dollars. And if she’d invested in real estate? The sky’s the limit.
That’s retiring in style.
[Editor’s Note: We are republishing this article to help out readers newer to our blog.]
What does YOUR retirement plan look like? Any factors we didn’t take into account in this case study?
Let me know your thoughts and opinions in the comments section below!