Financial Planning

The Power of Compounding

This is the factor that could really build wealth for young adults.

Most wealth is built gradually. Sometimes it is built without any great financial sacrifice. You can cite one factor that promotes wealth building perhaps more than any other – the power of compounding.

If you are decades away from retirement, you have a great opportunity to put that potential on your side by saving and investing through a tax-deferred retirement account. The next three paragraphs will show you just how remarkable the compounding in one of these accounts can be. These are hypothetical examples, but the math is certainly compelling.

As Michael enters his thirties, he starts contributing to the retirement plan sponsored by his employer. He initially puts $500 into the plan and directs $500 a month into the plan thereafter. He keeps doing this, month after month, and his invested assets benefit from a consistent 7% return. Michael retires at age 65. After 35 years, how much does his retirement plan account contain under these conditions? $210,000? No, those are just his total contributions across 35 years. With annual compound interest, at age 65 the account would contain $865,883.1

Twenty-five-year-old Megan works for the same employer, and she decides to start saving for retirement five years before her co-worker Michael. Like Michael, she retires at 65. Like Michael, she directs an initial $500 into her account and $500 per month thereafter, with the investments in the account returning 7% a year. The only difference is that she begins to save for the future five years earlier. At age 65, she is looking at $1,250,246.1

In the late stages of retirement saving, the effect of compounding grows. Twenty years after opening her retirement plan account at work, Megan sees a balance of $257,138. Just ten years later, the balance has ballooned to $591,839. A decade later, it has more than doubled again to $1.25 million.1

Three other factors are aiding the growth of Michael’s and Megan’s accounts. One, tax deferral; there was no yearly subtraction of assets. Two, a consistently good rate of return for the investments; there were no bad years, nor were there any spectacular ones. Three, they left the money alone; they refrained from taking loans or early withdrawals from their retirement plans.

These examples do disregard some realities. Retirement accounts come with administrative fees, and those annual fees (which in some cases can top 1%) can effectively eat into returns. As Money pointed out recently, the difference between a 1% annual fee and a 0.25% annual fee could mean $100,000 or more in lost compounding over 30 years.  The annual return on an account may of course vary greatly from year to year; real world investment performance is not so consistent. On a positive note, the examples also ignore the reality that many people increase their retirement contributions with age as their income rises. So, inflows into these accounts may grow and enhance compounding.2

The basic lesson, however, is clear. If you are a young investor with a chance to direct money into a tax-deferred retirement savings account, begin saving and investing for the future now. Time is truly on your side. If you wait ten or twenty years, you may have to contribute uncomfortably large amounts of money to your account each year to try and catch up to where you want to be in terms of saving – amounts your household finances may not permit.

 

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Citations.

1 – bankrate.com/calculators/savings/compound-savings-calculator-tool.aspx [3/8/18]

2 – time.com/money/5137127/retire-richer-401k-mutual-fund-fees/ [2/15/18]

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