How Compound Interest Affects Retirement Funds
In the good old days, young Americans went to work for an employer who promised them a comfortable retirement in the form of a pension plan, that is, a defined benefit plan.
Today, the onus is increasingly on the worker to set aside money for retirement in the form of a 401(k) plan or an IRA, i.e. a defined contributions.
The purpose of this post is not to explain the mechanics of pension plans. Rather, we want to show you the importance of saving as early as possible.
It all comes down to an elementary mathematical principle:
Compound interest occurs when the interest that accrues on a sum of money in turn accrues. It’s the strength of deceptive simplicity that quickly snowballs into wealth. This is why it is the concept that is at the heart of all finance.
The folks at JP Morgan Asset Management demonstrate the true power of compound interest in their 2014 “Guide to Retirement.”
Their example consists of three people who enjoy the same annual return on their retirement funds:
- Susan, who invests $5,000 per year only from age 25 to 35 (10 years).
- Bill, who also invests $5,000 per year, but from 35 to 65 (30 years).
- And Chris, who also invests $5,000 per year, but from 25 to 65 (40 years old).
Intuitively, it makes sense that Chris ends up with the most money. But the amount he saved is astronomically greater than the amounts saved by Susan or Bill.
Interestingly, Susan, who saved for only 10 years, has more wealth than Bill, who saved for 30 years.
This difference is due to compound interest.
You see, all the investment returns that Susan has earned over her 10 years of savings are snowballing – big time. It’s so bad that Bill can’t catch up, even if he saves for another 20 years.
Of course, if Susan saved like Chris…well, if you haven’t noticed, Chris’s savings are just Bill and Susan’s savings combined.
The longer you wait to start saving for your retirement, the more you miss out on the benefits of the incredible power of compound interest.
Here’s the chart, in slide form, from JP Morgan Asset Management.
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