A reader writes in, asking:
“Does it ever make sense to slow down the rate at which I’m saving for retirement, or even put it on hold completely, in order to direct money toward expenditures that could increase my income? I suspect that putting money toward additional education in my field would have a good payoff. But I also know that saving and investing is particularly powerful when I’m young. How would one actually go about doing such an analysis?”
To the first question: yes.
Investing in your own earnings potential is often a very good idea (e.g., by getting a particular certification, license, or degree in your line of work, or by putting money into a business that you’re starting), even if it means putting off saving for retirement for a brief period. This is especially true for people early in their career, because the increased earnings will be in effect for many years.
I did this myself, a little over 10 years ago. There was a period of almost two years (around age 23-24) when my wife and I saved nothing for retirement, because we were putting money into my publishing business. The business was growing, and it seemed likely that additional funding would pay off — and it has. The resulting increase in our income has significantly exceeded the return that we would have achieved via additional 401(k) savings. (Plus, now I get to do work that I find much more enjoyable than what I was doing before.)
How to Calculate a Projected Return
If you want to actually make a comparison of rates of return, you first need to come up with a year-by-year estimate of the cost and the payoff from the investment you’re considering. In some cases you may be able to find good statistics on the topic (e.g., how much more, on average, do people in your field with a particular certification earn than people without that certification?).
Then you can use the IRR function in Excel to calculate the rate of return from the projected cash flows. The tutorial in the previous link explains how to use it, but it’s pretty straightforward. You type the projected cash flows in a column of cells, with the cash outflows (i.e., the money you expect to spend) as negative values and the cash inflows as positive values. Then, in another cell, you use the “IRR” function, selecting the range of cells that includes your projected cash flows (e.g., “=IRR(A1:A17)”).
Then you can compare the calculated return from your projection to the return you would expect from additional investment in your portfolio. (Important note: in each case, you want to adjust the cash flows to account for taxes. For example if you expect an additional $10,000 per year of income, and you have a 25% combined state/local marginal tax rate, you’d enter $7,500 as the expected cash inflow in each cell.)
It varies quite a bit from one case to another, but it’s not at all rare for the rate of return from career-related expenditures to greatly exceed the rate of return you could expect from regular stock/bond investing.
How Risky Is It?
It is important, however, to recognize that comparing a projected rate of return from career-related spending to the rate of return you would expect from additional retirement savings isn’t an apples-to-apples comparison, as the risk level may be quite different.
For instance, if you’re a 23-year-old accountant, getting your CPA certification is very likely to substantially improve your earnings over the course of your career. Frankly, this is probably less risky than putting money into a stock index fund.
Conversely, investing a lot of money into an entrepreneurial endeavor can be super high-risk. You’re essentially buying a single stock (i.e., an undiversified investment), and it’s a riskier stock than your typical publicly traded company. (See, for instance, this cautionary tale I recently encountered of a man whose failed restaurant endeavor cost him his house.)
But, in summary, yes, investments in your own earnings potential are worth considering, even if they would require you to put saving for retirement on pause for a brief period. And this is especially true if:
- You are early in your career, and
- The hoped-for increase in earnings is very likely to actually occur (i.e., it is not especially speculative).
What is the Best Age to Claim Social Security?
Read the answers to this question and several other Social Security questions in my latest book:
|Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less|
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