Friday, May 26, 2006

Saving Early

Countless surveys and reports show that a majority of Americans, regardless of age, are woefully financially illiterate. The U.S. personal savings rate has been steadily declining over the past decade, even turning negative in 2005. According to many pundits, the problem is that youngsters are not learning financial responsibility and the importance of saving for the future. These bad habits follow them as they get older.

To fight this trend, some schools are promoting financial literacy at a young age and even starting savings banks. At Sunrise Valley Elementary School in Fairfax, Va, students operate the Sunrise Valley Savings Bank, a school branch of a local bank. There is no minimum balance and student deposits earn 5% annual interest.

Elsewhere, educators and financial institutions have sprung into action, teaching kids about basic money management skills. Indirectly, students will be learning about the power of the time value of money. The TVM is a central topic in finance and revolves around the concept that a certain amount of money received today is worth more than the same amount received sometime in the future. A variety of factors including inflation and the choice to consume or save play a role in this.

The basic TVM equation solved for future value: FV = PV (1 + r)n, where PV is the present value of the amount, r is the interest rate, and n is how long the amount is invested. The story mentions how a ten-year-old student, Nate, is depositing a $5 bill. If Nate continues to earn 5% on his savings until he retires at age 65, that $5 deposit will be worth $73.18, doubling nearly four times. If Nate continues his practice of saving $2 a week until he retires, he would have $30,414 when he retires. This is a slightly more complicated calculation, because there is a periodic payment being made, but trust me it’s right!

1. Near the end of the article, 11-year-old student William says he wants to buy a new skateboard. What is his opportunity cost of saving for a new skateboard?

2. The Sunrise Valley Savings Bank pays its members 5% interest, but it is reasonable to assume students will get higher returns for their money in the future. How much will Nate’s $5 deposit be worth in 55 years if he earns 6% interest? 8%? 10%?

3. To see the importantce of teaching youths to save early, access this savings calculator. If a 10-year-old student saved $1 every day and deposited $365 at the end of each year from now until retirement (at age 65), how much would he/she have at retirement in 55 years? (Hint: Starting amount = $0; Years = 55; $365 additional contributions made annually; and a 10% rate of return compounded annually)

4. Use trial-and-error with the savings calculator to see what annual contributions another student would have to make if he/she didn’t start saving until the age of 55 (ten years from retirement) and wanted the same ending amount. (Hint: Change Years to 10 and try different values for additional contributions until you have about the same ending amount.)

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  • At 2:59 PM, May 27, 2006, Blogger tim said…

    How about some reasons NOT to save:

    1. How much is Chris's net return after tax payable on interest?
    2. How much will account keeping fees affect Chris's net return?
    3. Chris is reinvesting after-tax interest, net of account keeping fees. What level of inflation will drive his returns negative?
    4. Is this level of inflation a reasonable likelihood?

    If the return on saving fiat money is negative, what should Chris do? ... Spend now? ...Invest in a real commodity? ...Work less? .. borrow this free money himself?

    What are current American levels indicate Chris has chosen to do?

  • At 6:51 AM, June 02, 2006, Blogger Ivan said…

    I'm saving for retirement. It makes sense to maximize a company's matching contribution if available.

    But I don't plan on retirement. I can't think of anything more boring.

    Why am I saving? Because people think it is a great idea.

  • At 2:27 PM, August 17, 2006, Blogger John Venable said…

    Here are some answers to schopenhauer's questions (May 27, 2006 post):

    1. Inside of a Roth IRA, the pretax return and after tax return are one and the same.

    2. There are several mutual funds and brokerage houses that waive custodial fees even on small accounts (Fidelity, one of the largest mutual fund managers, has such an account.) Most waive fees when the account balance reaches $25,000. One could add this wrinkle to the rate-of-return analysis, but it would detract from the primary lesson and would not be a meaningful number.

    3a. The nominal rates of return for large company stocks over the last 79 years (1925 - 2004) were 10.4 percent compound annually. Again the effect of account keeping fees is negligible.

    3b. If inflation averaged more than 10.4 percent, real returns would be negative. In reality the compound inflation rate from 1925-2004 was 3.0 percent.

    4. In the 79 year period referenced above, we experienced only four years when inflation exceeded 10 percent: 1946, 1974, 1979, and 1980. So, if history is a guide, a persistent inflation rate greater than an investment rate is not a reasonable assumption.

    5. If real returns turn negative, Chris should re-deploy his assets. Real returns less than zero are usually associated with high inflationary periods. In those times, investments in real estate, art, collectibles, and precious metals have tended to perform well.

    6. The American "Chris"es of the world are not big savers. Some reports estimate a drop to about 1% of income as compared to an average 7% over the last three decades.

    So Chris has decided to spend. Whether s/he has done so because they've concluded that saving is a bad idea is anyone's guess, including schopenhauer's.


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