There is a wonderful little classic book called, “The Richest Man in Babylon,” which now is available at no charge online. The book is a series of parables – set in ancient Babylon – which describe how anyone can amass a fortune and retire rich.
The secret is to set aside a portion of your earnings – 10% is recommended – without fail (“Pay yourself first!”), and then to use expert advice to have your money grow in a compounding fashion. As Ben Franklin put it, “Money makes money, and then the money money makes, makes more money.”
Let’s see if that advice still works today.
Let’s make some assumptions.
- First, as recommended in the book, you will set aside 10% of your earnings.
- Second, all amounts/returns will be considered after the effects of Inflation and after Taxation.
- Third, your goal is to receive the same “real” return on your money as you earned through your labor.
The second point needs a little explanation. If Inflation and the Taxation on nominal returns on your money completely eat up those nominal returns, then you wind up not increasing your wealth. And, your wealth is NOT working for you, but only to feed the FED, which is the cause of Inflation, and to feed the Tax Man.
If you indeed receive zero return on your saved Capital, then you never can achieve assumption three. Instead, you may use up your saved Capital during retirement, hoping that your money lives longer than you do.
With zero real return, you would have to work for 10 years for each year’s worth of Capital distribution you hope to receive during retirement. If you hoped to live off your money after 40 years of savings, then at zero real return, you could succeed only if you died four years later!
Even with positive real returns on your investments, today’s tax system will cause you grief. As your savings, with accumulated earnings, grows, then the future taxable return on your money will grow. Those returns on your Capital will be taxed at higher rates than your work earnings, requiring ever higher nominal yields to keep above a zero real yield.
So, let’s look at an example where the CPI grows 2% every year (a low-ball figure), and your return on investment (ROI) is 4%. After Inflation, you get 2% returns, but all 4% are taxed. If you’re at the 25% tax rate, then you lose another 1% of your ROI to taxes, giving a real return of only 1%.
If you work for 40 years at $50K a year, then you will have saved $200,000 ($50K x 10% x 40 years). Your real ROI after 40 years would be about $46,876, giving you a total of $246,876. A 1% annual real return on this sum would be just over $2,500 per year – hardly enough to retire on!
I’ve worked this out for several “real” rates of return (please see chart below).
It takes a real return of 7% before your earnings on saved Capital is more than your earnings from your labor! Please note that, while you are working, the real rate is reduced by 2% Inflation and also by an ever increasing tax bite on those investment earnings.
During the last year before retirement, your nominal return rate must be increased by 2% for Inflation and also by about 4% for taxes! Your nominal return needs to be around 13% to get your needed real rate of 7%!
Let that sink in for a while.
This example used some favorable assumptions. Is Inflation really 2%? Is it likely to go up, down, or stay the same? Every percent higher that the CPI is means an extra percent (plus tax on the ephemeral gains) that you have to earn.
Can you save 10% of your pre-tax earnings? The current US Personal Saving Rate is 5.5% of earnings, up from 5% or less the last few months. The long term Savings Rate is 8.39%! If you thought, “Well, I’ll just save 20% to 25% like the Chinese do,” just realize how hard it would be to save just 10% of your pre-tax earnings, year after year, from day 1 of your work lifetime.
Can you get 13% yields? Even “Junk Bonds” today pay much less than that; can you accept the risk of default? Remember too that any business you want to invest or loan money to also has to beat Inflation and the Tax Man before it can give you the 13% returns.
Stock Markets are cyclical. Right now they are priced to perfection, after company buybacks and government mandated zero interest rates have propped up stock prices almost to bubble levels. Stocks are unlikely to give you nominal yields better than 5% a year over the next 10 years (that probably is wildly optimistic as well).
The bottom line is, unless the FED is required to stop printing money – in order to stop Inflation – and stops manipulating interest rates to near zero (robbing you of potential returns), your return on your life savings will be well under what you need to retire.
And, unless the tax bite is lowered, you should plan on working ’til you drop! 99 out of 100 Americans won’t be able to save enough, and make their money grow enough, to retire.
Unless you have a plan to become one of that “1 Percent” you won’t be able to retire in the manner to which you’ve become accustomed. The FED and your elected representatives have seen to that.