Note: Fecundity took a look at the spreadsheet I used to calculate these numbers and found one formula error and a couple of simplifying assumptions that she refined (she built a more realistic tax calculation, for example). None of the changes affected the conclusion, and in fact it tilted things a bit further in Paul’s favor, so I decided to edit the original article to reflect her changes. Thanks Fecundity!
As I discussed earlier, I’ve been wondering about the difference in wealth between college graduates and skilled non-college graduates. I decided to do a comparison of the two career paths, and see what those big choices meant for someone later down the road. Specifically I wondered if I could answer a few questions:
- Can the late start in saving by the college graduate be overcome through higher salaries?
- Does the lower earning potential of a non-college graduate mean that the non-college graduate will be required to “work until they die”?
- Who will be able to quit the rat race first?
Fred attended college for four years, taking out student loans. Paul got a job at 18, straight out of high school. I wanted to see whether college was worth it, and whether attending college helped or hurt Fred’s chances of getting out of the “rat race,” and whether Paul was facing an unbelievable uphill climb to achieve the same goal.
I made a lot of assumptions. Both men work until age 65. Tax brackets as of 2006 are used (15% to 33%). Both invest in accounts returning 8% per year. Fred starts college at age 18, taking out $40K in loans ($10,000 per year). When he finishes college, he pays back 5% per year ($2000) . He puts aside 10% of his after-tax income for debt and investing. He pays the debt first. He invests the balance of the money. His salary starts at $27,000 and increases 4.5% per year over his life (average annual wage is $80,947).
Paul starts working at age 18. He invests 10% of his after tax income, and has no debt. His starting salary is $8.95 an hour and over his lifetime his average annual wage is $44,895 based on yearly increases of 3.5%.
Here’s what happens. Fred contributes less than 3% of his after-tax income to his investments until he’s 32 years old. He doesn’t invest more than Paul does until they are both 42 years old! His tax bracket jumps to 25% when he’s 26, and by the time he’s 25 he only has $2,000 saved, or approximately 6% of his annual pre-tax salary.
Paul, on the other hand, starts earning and investing when he’s 18. He doesn’t reach the 25% tax bracket until he’s 35 years old. However, at age 35 he has almost $75,000 saved, 231% of his annual earnings before tax.
Fred starts to catch up once his loans are paid off. His investing, starting when they are both 42, is now approaching 1.6 times more per year than Paul. However, by age 50 Paul has $328,000 saved; Fred still only has $164,000. However, since Paul had 4 times as much saved as Fred at age 35, this ratio of almost 2 to 1 is a huge improvement.
As we approach retirement age, Fred is living a pretty good life. His salary is in the mid-six figures at age 60 ($143,000). Paul is making half as much ($76,000). Fred is moving into the top tax bracket, and socking away more than $10,000 per year in savings. Paul is still saving about $500 per month and is just preparing to move into the 28% bracket.
At 65, Fred is making $180,000 per year. He has over $777,000 in savings (4.3 times his salary). His savings in retirement will generate $31,000 per year at 4%, the rule of thumb used for retirement withdrawals for a sustainable amount assuming a normal US life expectancy (78). This means that he will have to live off 24% of his last after-tax salary, plus whatever government benefits or pensions or capital gains from selling his house that he can obtain.
Paul, on the other hand, has more than a million saved ($1,189,000). He NEVER saved more than $600 per month in his whole life. His final salary was $90,000. He will have $47,600 per year (using the 4% rule) to live on; still only 67% of his after-tax salary, but much closer than Fred to a reasonable amount.
Amazingly, Paul only invested a total of $177,000 over his 48-year working life. Fred invested more: $231,000. Yet Paul’s final portfolio contained 7 times more cash than he invested; Fred’s was only 3.36 times as much as he invested.
Paul ends up with $412,000 more than Fred. Paul, at age 65, has a far better chance of surviving in comfort off his $1 million portfolio and a lifestyle presumably suitable for someone who makes less than $100,000 per year. Fred, on the other hand, will struggle to survive if he maintains a lifestyle built around a $180,000 per year salary with only $777,000 in the bank.
Now Fred, of course, may have bought a house in a metropolitan area when he was 40 and now can sell it for hundreds of thousands in profit; however, I’m willing to bet that unless he was highly disciplined he still has a mortgage, and the chances of making over $400,000 in profits on a home are small (not impossible – but small). Fred may also have had access to tax-advantaged plans and matching programs through company 401(k)s and so forth that Paul might not have had. Even if all of these scenarios play out perfectly for Fred, he barely catches Paul. Even if he DID have $1.3 million saved, it’s still only enough to guarantee 29% of his after-tax retirement income.
So what does this all mean? Should every 18-year old skip college and go straight into the workforce? The short answer: no. Assuming that you did start earning at 18, you would need to be a highly disciplined saver, and not everyone is. If Paul didn’t start saving until he was, say, 29, he has only $665,000 in savings at age 65. Those extra 10 years after high school – when he saved only $18,000 – made an almost half million dollar difference at the end of his working life. Ask yourself how many people at age 18 can save 10% of their salary. They exist, sure, but realistically very few people have that discipline.
What’s the solution, then? I think if you go to college, avoid student loan debt if you can. How? Don’t go to an expensive school if a less-expensive option is available. If Fred’s student loan for $40,000 disappears, he has $1.3 million when he retires. Still not enough, probably, but $650,000 more than he would have had. That debt makes a huge difference.
A second tip is start investing early. Very small amounts invested early in your life will grow significantly more than the same amount (or an even greater amount) invested later. If you managed to save a few hundred dollars in high school, that’s far more significant than thousands when you’re in your 40s. Think about that – a tiny bit of sacrifice early on will make you richer than a much larger sacrifice later in life, when you think you have “too many expenses.”
A third lesson: consumer debt will cripple your chances of accumulating substantial savings. I assumed both men were exceptionally disciplined and never incurred any debt other than student loans (in Fred’s case). If either one had spent that 10% per year on credit card debt instead of investing it, their future prospects for quitting work before death plummet to almost zero.
A final lesson: even small amounts make a huge difference. Think again about this statement: “He [Paul] NEVER saved more than $600 per month in his whole life.” Isn’t that amazing? Not one month in his life did he ever save more than the cost of an iPhone plus accessories, or much more than digital cable plus cell phone service. He didn’t save thousands per month, just $600. If that’s not enough, keep in mind that was the absolute maximum he ever saved in a month! On average, he only saved around $300 per month over his life!
Here were my original questions, and the answers I discovered:
- Can the late start in saving by the college graduate be overcome through higher salaries? Not really, unless the college graduate’s salary is significantly higher or the savings rate is substantially greater.
- Does the lower earning potential of a non-college graduate mean that the non-college graduate will be required to “work until they die”? Absolutely not – in fact, if the non-college graduate is a disciplined saver, the opposite is true.
- Who will be able to quit the rat race first? Based on my model, the non-college graduate – but the real indicator is who starts saving the highest percentage of their income earliest in their career.
Don’t take too much of this as gospel. This was an illustration only, and of course a million variables come into play about spending habits, debt, housing, career growth, investing choices and so on. The purpose of this exercise was to challenge my context, and hopefully yours too. Don’t always assume that just because the college presidents of America tell you that you need college that you do. I had a lot of good times in college, and I wouldn’t trade them for anything. But don’t kid yourself – colleges are businesses that want your tuition to fund their foundations and football teams and new buildings and conferences and so on. They want you to take out big loans, because they don’t care that you start your earning life saddled with debt as long as they get their tuition revenue.
The moral of the story is that you shouldn’t believe a thing just because everyone else says it’s true.
(photo by MarkWallace)