Why are Americans still financially illiterate in 2021?
In my last year in pharmacy school, I had a conversation with one of my classmates about something called a Roth IRA. Apparently, it was something he just learned about and his eyes were filled with excitement as he explained to me, “A Roth IRA is the easiest way to become a millionaire. ”. Unfortunately, I wasn’t the most financially literate, or fiscally responsible, so I didn’t really do much with that information at the time. Miraculously, that thought did plant a seed that led me down a path of binging through all the IRS tax laws on tax-advantaged plans (e.g. 401k, IRA), Boglehead forums, and every personal finance post I could find on the internet over the next 4 years.
Why Do I Think Americans are Financially Illiterate?
As personal finance discussions occur more frequently amongst my colleagues, or rather, a select minority of them, I can’t help but wonder if the current generation of Americans will actually be able to retire. Personal finance seems to be a topic that many avoid like the plague and hope it just all magically works out in the end. To be fair, the approach previous generations had towards personal finance has shifted drastically and it’s important that we recognize that and implement changes that allow us to secure our own financial independence in the modern era — be it in your early 30 and 40s or the more traditional 60s. However, from what I’ve seen so far, this doesn’t appear to be the case.
Saving for Retirement now is Different than before
The path towards retirement was very different for Baby Boomers (1946–1964) and Generation X (1965–1980) vs. the largest working force in 2021: Millennials (1981–1996). Here are a few reasons why:
- Longer lifespans: Americans nowadays are living longer than they were in the last century. Just for a few comparisons, average life expectancies per the CDC were as follows over the years: 1900 (47.3 years), 1950 (68.2 years), and most recently in 2018 (78.7 years). So objectively speaking, Millennials must save more than previous generations as we are just living longer than previous generations.
- Social Security alone doesn’t cut it. If you think social security has you covered. Think again. According to Mark Hebner, unless your family is currently earning under $30,000, you will need another monetary source to supplement your retirement income. In fact, the average monthly social security benefit in 2021 was $1,543, or $18,516 annually, and only replaces an average of 34.5% of one’s pay. Even then, some predict that social security may be depleted by 2035. This underpins why every American should be contributing towards other financial vehicles such as tax-advantaged accounts (e.g. 401k, IRA), real estate, brokerage accounts, etc.
- Retirement Contributions are either not enough or absent: According to Vanguard, the average 401(k) account balance in 2020 was $106,478 with the median coming in at a disappointing $25,775. Of course, there are many factors that influence one's account balance with age being a significant one. Even then, the average and median 401(k) balances for those who are 65 and up are $216,720 and $64,548, respectively. Given the cost of living nowadays, I would imagine that would not be enough to sustain for the next 10–20 years of life. It also doesn’t really help that the U.S. Census Bureau found that only 32% of workers are contributing to an employer-sponsored defined contribution plan.
- Pension plans: Perhaps as a millennial, we just got unlucky. In the generations before us, one would be able to stay with a company forever and retire with one of those lucky defined benefit plans, aka pension plans. Which, appears to be quite a rare find nowadays given that only 16.2% of Fortune 500 companies offered a pension plan in 2017 as compared to 57.6% from 1998. Why is that happening and why are more and more companies trying to dump their pension plans? Simply put, pension plans are extremely expensive and 401(k)s and other defined-contribution plans are just more cost-effective for the employer.
How much do we even need to save for retirement?
This is the million-dollar question, or perhaps the 2 million-dollar question when accounting for 30 years of inflation, but how much do we even need in retirement? I obviously don’t have the answer, but I do have a popular method that many, including myself, have used to get a rough idea of what our nest egg should ideally look like so we’re not working for the rest of our lives.
- The 4% rule: This is a general rule of thumb and a basic starting point for estimating how much one may need in retirement. The basic idea behind this rule is that we should be able to retire in peace without ever having to worry about running out of money. Based on historical data on stock and bond returns between 1926–1976, a 4% annual withdrawal rate has been estimated to be a safe amount to accomplish just that.
- Median household income in the US: Retirement income and lifestyle is usually relative to one’s income and it makes sense to estimate ones spending in retirement based on that. To give us an idea of what a nest egg may look like for the average American, the median household income in 2019 was $68,703.
- Retirement savings goal: To calculate a rough estimate of where one's retirement savings should be, a good starting place would be to multiply their annual income x 25. Thus, $68,703 x 25 = $1,717,575.
Although this is just a general rule of thumb, you can easily see why I think the way I do: there’s currently a large gap between retirement savings and the ideal retirement savings goal. Of course, there are many reasons why one may not be able to contribute a substantial amount of money, but I also think that’s why many Americans are financially illiterate. Surprisingly, you don’t need to make a lot of income to build a sizable nest egg. There’s a reason why Albert Einstein once said, “Compound interest is the eighth wonder of the world”. (P.S. I’m not sure if he actually said that, but that’s what the internet says and we all know the internet is #truths).
The Secret To Building Wealth: Compound Interest
Again, let’s use some concrete examples here with some numbers that are understandable to the average American. Many Americans can relate to purchasing a cup of joe for $5/day, if not more. $5/day x 30 days = ~$150/month on average. Assuming you start from $0 initial savings and you began saving $135/month because you started making your own coffee for $15/month, you will have contributed a total of $48,600 over 30 years. If you invest that money and assume a 7% average return rate (minus inflation & taxes), your total contribution of $48,600 in coffee savings alone, will have grown to a total of $153,026.47! Imagine how much more that can grow if you factor in other “necessities” like subscriptions to Netflix, Spotify, or Amazon Prime.
To relate it back to the example before of a $1.7 million dollar nest egg, one could achieve that with a monthly contribution of $1,500 when compounded for 30 years. Although that isn’t a small amount, it’s also not as difficult as it may seem when you take advantage of tax-advantaged accounts that were intended for retirement savings (e.g. 401K). In fact, one can even reach their goal faster if an employer matches a percentage of their contribution since that’s literally free money.
Bottom line: the sooner you invest in the market, the easier it is to save. For example, I used 30 years of compounding assuming most individuals reading this would likely be in their late 20s or early 30s. However, if one was to invest beginning at age 20, compounding over 40 years would only require a monthly contribution of $715 — only half of what is required if you started at 30 — to end up with a $1.7 million dollar nest egg!
We Control our Own Destiny
Millennials and future generations, unfortunately, don’t have it as well off as previous generations with their financial safety nets of pension plans and social security. We are dealt the hand we have, but we have the opportunity to change it if we so desire. I strongly encourage those of you who have not started to save and invest to begin to do so. As a Chinese proverb once said, “The best time to plant a tree was 20 years ago. The second best time is now.”
