A ton of personal finance information awaits anyone with an interest, but we need a frame of reference to even begin understanding all of that information in the first place. Let’s take 10 minutes to talk about what “retirement” really means, and how that applies to financial independence and savings.

Retirement is simply the point where our resources can cover our financial needs for the rest of our lives, without us working any more. That’s it. There’s no special age, there’s no magic number, and there’s no “one right way” to calculate when people should retire if they want to. While a lot of factors contribute to figuring out retirement (such as how long we’ll live and how much we need), retirement is simply the point where we decide that we can afford to quit working, if we want to.

Financial independence (FI) goes one step further, but remains just as simple: FI is the point where our resources can cover our financial needs for the rest of our lives, *regardless* of how long we live. Therefore, the difference between retirement and financial independence is having enough extra resources so that we don’t have to guess how long we’ll live.

Two Challenges: Living Now and Passing Away “On Time”.

The first challenge is a simple question: why should I plan for retirement now, when I can barely cover my current expenses? That’s a legitimate question. It doesn’t make sense to squeeze money into the future when it’s hard enough to get by in the present. Maybe the price of gasoline goes up. Maybe the water heater breaks and we have to replace it. Maybe we get ill or injured. It can feel like we have an endless number of expenses.

The second challenge appears in an awkward place of trying to estimate when we will pass away. We don’t want to miss out on enjoying the resources we saved up, but we also don’t want to run out of resources too soon, because we will be in a much more difficult position to get more resources. The fear of passing away “too early” or “too late” can make people delay planning for retirement.

The answer for both challenges is simple, but not easy. Establishing and following a *savings habit* makes a small impact in the short term, and a huge impact in the long term. Like any healthy habit, we see only small results right away, but our good habit slowly yields *great* results. To see what a healthy savings habit can do for us, we need to understand how money can grow faster than what we save.

Decoding the Savings Arithmetic

We make our money grow by investing it, which is a fancy term for saying that we save our money in places where we get back a little bit of a bonus. Maybe we invest in “the market”, via stocks, bonds, or real estate. Maybe we invest in other financial products. Right now, the specifics don’t matter. Just understand that investing our money means saving it, then getting a little bonus (often called “returns” or “interest”) every so often.

Let’s say we save a dollar a year, and we get 5% yearly returns. That means every year, we get a bonus of five cents for every dollar we save. Why 5%? Because that’s really close to the long term average most people see when they invest their savings, after combining a bunch of factors like inflation, ups and downs in financial markets, and so forth. That remains true even now, if you’re interested in checking the numbers. We save a dollar in the first year, and get a five cent return, for a total of $1.05.

The second year, we save another dollar. Now we have $2.05. At the end of the year, five percent return of that gives us a ten cent bonus (five cents for each of the two dollars), so the end of the second year sees our total savings reach $2.15.

Now, watch what happens on year three. We add another dollar, and bring our savings to $3.15. When we calculate our return at the end of the year, we get 16 cents, for total of $3.31. *Where did that extra penny come from*?

Year | Add a Dollar | Bonus | Total | Total Bonus |

1 | $1.00 | $0.05 | $1.05 | $0.05 |

2 | 2.05 | 0.10 | 2.15 | 0.15 |

3 | 3.15 | 0.16 | 3.31 | 0.31 |

The answer is called “compound interest” or “compound returns”. Remember that when we get our bonus at the end of the year, the bonus is 5% of everything we saved so far, *including* the bonus from previous years. That extra penny shows up in year three because our cumulative bonus got big enough that it started earning its *own* bonus.

Returns help our money grow. *Compound* returns are how our money can grow significantly faster than what we save.

Check this out — after eight years, we saved eight dollars, and we earned a total bonus of $2. The pile of money is now big enough ($10) that we earn a bonus half dollar every year.

Year | Add a Dollar | Bonus | Total | Total Bonus |

4 | $4.31 | $0.22 | $4.53 | $0.53 |

5 | 5.53 | 0.28 | 5.80 | 0.80 |

6 | 6.80 | 0.34 | 7.14 | 1.14 |

7 | 8.14 | 0.41 | 8.55 | 1.55 |

8 | 9.55 | 0.48 | 10.03 | 2.03 |

In 14 years, we reach an important milestone. We “saved” $14 (a dollar a year), but we actually have more than $20 thanks to our bonuses. And now, every year we earn at least a dollar bonus! We finally passed the point where *every year we earn more in our bonus than what we actually save*! Heck, instead of putting in a dollar, we could take out a dollar every year, *for the rest of our lives, no matter how long we live*, and our savings would never shrink.

Year | Add a Dollar | Bonus | Total | Total Bonus |

9 | 11.03 | $0.55 | $11.58 | $2.58 |

10 | 12.58 | 0.63 | 13.21 | 3.21 |

11 | 14.21 | 0.71 | 14.92 | 3.92 |

12 | 15.92 | 0.80 | 16.71 | 4.71 |

13 | 17.71 | 0.89 | 18.60 | 5.60 |

14 | 19.60 | 0.98 | 20.58 | 6.58 |

This happens in 14 years. Not 30 years, not 20 years, not even 15 years. 14 years for 5% compound returns to give us an extra dollar every year from now on.

Did you notice something else? While it took 8 years for our total savings to reach a point where it earned 50 cents a year, it only took 14 years, *not* 16, for our total savings to reach a point where it earned a dollar a year. We didn’t need to save for double the time to make double the bonus.

If we want to earn a bonus $1.50 a year, that happens at year 19. Two dollars of returns a year happen at year 23. Notice how it takes fewer and fewer years to get to the next multiple, as long as you keep saving a dollar a year? *That* is compound returns.

Year | Add a Dollar | Bonus | Total | Total Bonus |

15 | 21.58 | $1.08 | $22.66 | $7.66 |

16 | 23.66 | 1.18 | 24.84 | 8.84 |

17 | 25.84 | 1.29 | 27.13 | 10.13 |

18 | 28.13 | 1.41 | 29.54 | 11.54 |

19 | 30.54 | 1.53 | 32.07 | 13.07 |

20 | 33.07 | 1.65 | 34.72 | 14.72 |

21 | 35.72 | 1.79 | 37.51 | 16.51 |

22 | 38.51 | 1.93 | 40.43 | 18.43 |

23 | 41.43 | 2.07 | 43.50 | 20.50 |

At year 25, we saved a total of $50, half of which is returns.

At year 28, just short of the span of some people’s careers, our yearly bonus reaches almost $3 a year, three times what we’re saving. 28 years of saving a dollar a year, means we can receive $3 a year for the rest of our lives. Want to save for 33 years? Now we get $4 a year. Our yearly bonus grows faster and faster, thanks to compound returns!

Year | Add a Dollar | Bonus | Total | Total Bonus |

24 | 44.50 | $2.23 | 46.73 | $22.73 |

25 | 47.73 | 2.39 | 50.11 | 25.11 |

26 | 51.11 | 2.56 | 53.67 | 27.67 |

27 | 54.67 | 2.73 | 57.40 | 30.40 |

28 | 58.40 | 2.92 | 61.32 | 33.32 |

29 | 62.32 | 3.12 | 65.44 | 36.44 |

30 | 66.44 | 3.32 | 69.76 | 39.76 |

31 | 70.76 | 3.54 | 74.30 | 43.30 |

Want to get really crazy? Because our savings will never go down, our kids (or whoever is in our will) will inherit this amazing yearly bonus. They will get $3 a year for the rest of *their* lives. If they manage the savings as well as we do, then the next generation gets the *same* bonus! And so on. Once we get it going, compound returns feel like an ever growing resource that takes care of us, and the people we care about.

It’s Not a Dollar a Year.

To be sure, this is a simple set of charts. Nobody is going to save a dollar a year, then retire with $50 in the bank. You might have already started plugging in your own numbers. After all, if a dollar a year for 28 years gets you $3 a year for the rest of your life, then $10,000 a year for 28 years gets you $30,000 a year for the rest of your life. But most people can’t save $10,000 a year.

The Modern Reality of Retirement Planning

We arrive at four pieces of good news, and two pieces of scary news. The good news first.

One, you can start small. Most people earn more money later on in their careers than they do in the beginning of their careers.

Two, the longer you work and save, the greater (and faster) that your bonus multiplier grows.

Three, you don’t have to start at year one. If you already have some savings, you may be in the position of starting at year three, or year eight.

Four, if you plan to have other sources of income (like a pension, or social security), then that counts as part of your retirement income.

Next, the scary news.

The sooner you establish a savings habit, the bigger of a multiplier you can achieve at the end. Conversely, the *longer* you wait, the more limited you become. “Catching up” becomes increasingly difficult. Some people love what they do, and work their whole lives. Others do so because they have no choice. They waited too long. They must work to survive and their options are limited in their sunset years.

Pensions and social security are becoming more perilous. Most companies and government entities are leaving the responsibility of retirement savings to their employees.

How Do We Figure Out How Much We Need to Save?

The bottom line is this: we need to know how much we spend in a year. No loose estimations. We can add up our check registry, use an app to track our expenses, or look over all of our financial statements. If someone else covers some of our expenses e.g. health insurance pays for our medications, we need to know that too. What is the sum total of our expenses for the year?

That’s how much money we need to earn in yearly returns to live in our current lifestyle, indefinitely. Financial independence typically occurs at 20x to 25x of our yearly expenses, while retirement needs somewhat less than that, depending on our expenses and how long we plan to live. That may sound like an incredible amount of money, but we saw how compound returns can really escalate to help us, if given enough time.

How Long Will it Take to Save Enough for Retirement?

Average lifespans are increasing. Do you know what the average life expectancy is, for someone born in the last ten years in the USA? One hundred. One hundred years of life. That’s the *average* expectancy, so half of them are expected to live even longer than that. Which means we need to save more than our parents did, because we’re going to have more retirement years than they did.

I’ll point you to this article on Mr. Money Mustache. In essence, the article has you figure out your savings rate, then extrapolates how many years it would take to reach financial independence at that savings rate.

The article illustrates a couple of important concepts: the more we live below our means i.e. the more we save, the sooner we can retire. If we keep our expenses the same when our income goes up, we can significantly shorten the time it takes to achieve retirement or even financial independence.

How Do I Start?

Any way you choose, is the right way to start! Whether you begin putting bits of money into a savings account, or automatically deduct part of your regular paycheck into a retirement account, anything you do to start the savings habit is a step in the right direction. Make a commitment to yourself that this account is for the confidence and enjoyment of your future self.

You don’t have to give up enjoying today for the sake of the future, but the more you watch your retirement account grow, the more you entrench healthy savings habits that pay off big down the road. Savings may be the most boring healthy habit ever, but starting the habit now makes it easier to grow, which in turn opens the door to confidence and excitement for your future!