How Does A Retirement Nest Egg Work? The 5 Basic Elements

Retirement nest eggOne of life’s questions that should be asked more often is “How does a retirement nest egg work?” Too many people assume it is a complicated topic, while it is actually straightforward. This article explains the five basic elements effecting a retirement nest egg.

In a previous career, I learned to explain something in its simplest form possible. Removing all the bells and whistles and working with the basic building blocks. In this article, I will attempt to do the same with retirement.

Five basic elements

Breaking down retirement to its bare bones, we find that there are only five basic elements playing a role. There is one constant, one outcome and three activities. These are time, wealth, work, save and retire.

In order to make the explanation simple yet complete, we need to define each of the elements before we discuss their interaction.

  • The constant: Time

For the purpose of this article, time is interchangeable with age. Of the five elements, time is the only one you cannot control. You cannot change it in any way.

  • The outcome: Wealth

Total retirement nest eggWealth refers to the total retirement nest egg that you would have amassed by the time you retire. It is the result of your efforts over time. More specifically, wealth refers to income generating assets, not the car or the furniture.

The discussion does not imply any specific level of quality or any investment type. It is simply an imaginary quantity to illustrate that wealth is the product of the other four elements.

  • Three activities

Work represents any economic activity that produces an income. This could be a regular job, owning and managing your own business, or juggling multiple gigs.

Save is any method by which you accumulate a nest egg. It could be compulsory, as per the laws of a country. In the absence of a bureaucratically driven contribution, it is with the decision not to spend all your income and to invest a portion instead. It does not imply any level of quality or any type of investment. It is simply the act of saving a portion of income.

Retire is self-explanatory. It is the voluntary withdrawal from the workforce, the end of generating an income through full-time work and starting to live off the income from your retirement nest egg.

Time and wealth

Wealth (on the vertical axis) will increase or decrease as time (on the horizontal axis) goes by, indicated by a red graph segment.

Time and wealth graph

First activity: Work

Let’s assume that you start to work at the age of 25. Generating an income will contribute towards your survival, it will pay the bills and allow you to buy things. However, work without saving will do nothing to build a retirement nest egg.

How does retirement work : Work

Second activity: Save

If you have a job that contributes toward a social security fund (the US for example) or retirement fund, you are fortunate. It implies that you have started saving for retirement the moment you started work.

Not everybody is that fortunate. Many countries do not have a mandatory contribution towards a retirement benefit and it is up to the individual to save a portion of his income. In these cases, workers will typically start to save later in their working career. For this example, let’s assume saving starts at the age of 35, as shown in the graphic below.

The key to building a sizeable nest egg is not how much you earn, but how much you save. Involuntary savings is an obvious advantage, but should not be your only tactic. It is better to consider total savings, compulsory and chosen, monthly or otherwise.

The total amount that you save over time, together with interest and/or dividends accrued along the way, will determine the size of your retirement nest egg.

In the graph below, X indicates the desired size of the nest egg.

Third activity: Retire

Retirement implies the end of earning an income from full-time work. This also implies the end of saving towards the retirement nest egg.

As you start to draw an income from the nest egg, it becomes smaller. Generally, this rate of decrease is slow at first, but picks up as you get older and need more specialised (more expensive) care.

It’s a matter of green and red; plus and minus

In the graphics above, green represents save and red represents retire. It symbolises the effect each have on your retirement nest egg.

Save (green) means that your nest egg will increase. Retire (red) means the opposite; your nest egg will decrease.

Are there other possibilities?

Yes, there are many possible combinations of the five elements. Each unique combination will similarly deliver a unique result.

Let us consider four commonly asked questions. The answer will cover a broad range of possible combinations.

Question 1: Can my nest egg grow without any saving?

Keep in mind that our earlier definition of wealth was “income generating assets”. That implies that your investments will grow by the amount of interest or dividends it receives. However, this growth will be at a much slower pace, definitely not at a pace to achieve your desired nest egg by your desired retirement age.

The ideal is to enjoy the advantage of compound interest while simultaneously saving at regular intervals.

Question 2: The example shows saving from the age of 35. What would be the effect if I save from the age of 25?

Saving from a young age has a profound effect on your retirement nest egg. When it comes to saving over a medium to long-term, time is your best ally.

If you start to save at age 25 instead of 35, two things will happen.

First, your nest egg will start to grow 10 years earlier, and assuming the same level of saving, you will reach your retirement nest egg at age 55 instead of 65.

Secondly, if you do not stop saving at age 55 and continue to save as you have done before, you will accumulate a much larger nest egg. Not only through your continued saving, but also through an additional 10 years of compound interest. You will reach retirement at 65 with a significantly larger amount than the original amount at X.

Question 3: What would happen if I take a sabbatical after mid-life?

A sabbatical can almost be considered a temporary retirement. You will not generate an income during this time and your nest egg will only grow through interest and dividends. This is a situation similar to the one described in Question 1.

For the purpose of this explanation, let’s assume that you enjoy a sabbatical from age 55 to 60. During this period the red graph segment will almost flat line, and only go back to the previous growth rate after assuming work and saving at age 60. The result is the shortfall of the nest egg, well below the desired X level.

Question 4: Can I reduce the rate at which my nest egg decreases after retirement?

The rate at which you deplete your retirement nest egg, is dependent on a number of factors. Here are three to contemplate:

  • Consumer behaviour

One of the most important factors is consumer behaviour. It determines your spending patterns and the rate at which you will draw from your retirement nest egg.

  • Lifestyle

Most couples scale down at or after retirement. Many consider a smaller home, possibly in a less expensive area, possibly even in another country. Lifestyle is closely related to consumer behaviour and will have a direct effect on your spending. A lavish lifestyle requires an equally lavish post-retirement income.

  • Generating income after retirement

Any income generated from a job or business after retirement, will have a positive effect. It will either decrease the amount you need to draw from retirement savings or improve your spending power. Or both.

Taking a part-time retirement job has benefits beyond the financial rewards. Turning that hobby into a small business can be very rewarding, financially and otherwise.

The graphs and answers to the questions have illustrated how the five basic elements interact. Although simple to understand, each one is a crucial building block that you must use wisely to achieve your desired retirement outcome.

“You know that retirement is coming. It isn’t as though it just shows up one day and takes you by surprise, so you need to get ready for it” – Batya Shevish, Warren Buffett

I would love to have your thoughts on these basics.

PS: Please don’t forget to share it with a friend.

2 COMMENTS

    • Hi Louise, I’m glad the article could shed some light on the topic; it is so important for people to make it part of their everyday life!

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