Compound Interest: The "Secret" to Retirement Planning
Take advantage of compound interest to grow your nest egg over time.
Compound Interest: the 8th Wonder of the World
Albert Einstein famously said: "Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it."
Let’s understand more about compound interest, its effect on saving for long-term goals like retirement, and how you can take advantage of this 8th wonder of the world.
Compound interest is the interest you earn on interest.
Here’s a very simple example. Say you invest $100.
After 12 months, you get a 5% return ($100 x 5% = $5). Now you have $105 invested.
After another 12 months, you get another 5% return ($105 x 5% = $5.25). The $0.25 is compound interest – interest you earned on interest. And now you have $110.25 invested. Your money grew for you! This is the "secret"* to retirement savings.
It’s hard to imagine the long term effects of compound interest because our brains think in a linear way, not an exponential way. And compound interest has the potential to grow exponentially.
Warren Buffett, the greatest investor of all time?
Warren Buffett, the billionaire CEO of Berkshire Hathaway, is generally considered one of the greatest investors of all time.
Morgan Housel, behavioral finance writer, writes that compound interest is the most overlooked fact about how Warren Buffett got so rich.
Warren Buffett started investing at age 10, and he’s now in his 90s, so he’s been investing for 80+ years. According to Housel, “Effectively all of Buffett’s financial success can be tied to the financial base he built in his pubescent years and the longevity he maintained in his geriatric years.” This is the value of compound interest.
Two Savers: An Illustration of Compound Interest
Here’s another example, from The American College for Financial Services.
Lori invested $5,000 on her birthday at age 25 and continued saving this same amount until age 34, 10 total payments. Peter invested $5,000 on his birthday at age 35 and continued saving this same amount until age 65, for 30 total payments. They both earned an 8% rate of return on their investments.
At age 65, how much did they each have?
Lori’s $50,000 savings grew to over $728,000 while Peter’s savings was only $566,000. Meanwhile, Peter contributed 3 times as much as Lori! Lori accumulated 14.58 times what she saved. Peter accumulated only 3.78 times what he saved.
Below is another chart from The American College for Financial Services that shows in red how much each person saved, and in blue the compound interest they gained at age 65. This is the power of compound interest, which is also the power of time!
By saving early, Lori is able to consume $100,000 more than Peter before retirement, and she ends up with more assets in retirement too.
Use compound interest to grow your nest egg.
So what should you do, if you’re in your mid-career and you didn’t start investing when you were 10 like Warren Buffett? Save today! There is no time like the present.
The Social Security Administration actuarial tables show that a 40 year old in the US will likely live about 40 more years. That means more time for your savings to compound.
Take action today.
Enroll in your employer’s retirement savings plan (such as a 401k) for automated savings with each pay period. Don't have a 401k? Contribute an individual retirement account (IRA or Roth IRA).
If you already contribute to your 401k, increase the amount you save by 1%. Enroll in an automatic 1% annual increase. These automated behaviors have been shown to significantly increase the amount savers can accumulate because you don’t have to think about it each time.
As always, this is not personalized advice. Talk to your financial advisor about your personal situation.
*Please know I'm joking, just a little, about the "secret" to retirement savings being compound interest. Compound interest impacts the ability for retirement savings to withstand inflation and last your whole life. But obviously, the real "secret" to retirement savings is literally, to SAVE a portion of your income for retirement instead of spending it on your life now.
Already contributing the full amount to your employer retirement savings plan and want other ideas of how to save for retirement? Reach out.