The Miracle on Retirement Street, otherwise known as compound interest
As we enter the holiday season and can’t wait to see the classic Miracle on 34th Street on TV, those of us saving for retirement should be grateful for a miracle that compounds the savings in our 401(k) accounts.
Albert Einstein once said, “Compound interest is the eighth wonder of the world. Whoever understands it, earns it… whoever doesn’t…pays for it.”
Compounding is an important tool to help consumers increase the assets of all their financial accounts, not just their retirement savings accounts, making it a “miracle” that Americans should be grateful for all year long. in addition to the holiday season.
However, you can only enjoy the benefits of compounding if your assets are invested. If you withdraw money from a savings account, your balance doesn’t just decrease by the amount you withdrew — you also lose the compound interest those assets would have accrued if they hadn’t been withdrawn. That’s what Einstein meant when he said those who don’t understand compound interest pay for it.
Savers who cash out their 401(k) accounts prematurely aren’t just losing money to early withdrawals and tax penalties. They also lose the additional retirement income that their savings would have accumulated through funding if they had not Cashed.
A retirement saver who cashes in a 401(k) account with a balance of $5,000 at age 30 would lose over $52,000 in compound savings value by age 65, assuming the account grows by 7% per year.
To further demonstrate how compounding intensifies the destructive effects of cashing out, Fidelity Investments found that a hypothetical 30-year-old employee cashing in a $16,000 401(k) account today could lose more than $145,000 in during a 26-year retirement – or up to $471 in cash per month. Aon Hewitt reported that a hypothetical employee who cashes in three times over his working life reduces his total retirement savings from more than six times his salary to 1.25 times his salary.
Likewise, if you leave your 401(k) account in your previous employer’s plan when you change jobs, you also lose long-term compound savings. In its 11th annual survey of defined contribution plans and fees, released earlier this year, New England Pension Consultants found that the median record-keeping fee for plan participants is $57. If a hypothetical 30-year-old changed jobs today and left behind their 401(k) savings account in their former employer’s plan, they would lose $2,052 in fees on that age-locked account. 65 years old.
But that’s not all, it gets worse. This hypothetical 30-year-old man doesn’t just lose $2,052 in fees. They also lose compound savings that the $2,052 would have gained. If we again assume that the account’s annual rate of return is 7%, the $2,052 would have grown to $8,488.07 by the time the hypothetical 30-year-old turns 65. The problem is then “aggravated” if you have several blocked accounts.
Americans can maximize the retirement savings benefits they receive from the funded miracle by transferring their savings into their new employer plan each time they change jobs. Rolling in at every job change ensures that your hard-earned assets are never cashed out and you are not stuck with multiple retirement savings accounts.
Consolidating your retirement savings as you move from job to job also ensures you never lose track of your assets. Between 3% and 5% of all retirement accounts — 2.8 million to 4.8 million accounts — have outdated account holder addresses on file, according to Boston Research Technologies. Plan sponsors have the power to unilaterally transfer escrow accounts with less than $5,000 into safe-haven IRAs, but you wouldn’t know if your savings ended up in a safe-haven IRA if the plan sponsor sends the notice. to an out-of-date address.
From a compound perspective, a safe-haven IRA depletes your savings over time because the money market funds that underlie safe-haven IRAs currently have extremely low interest rates. These rates, which typically range from 0.1% to 0.5% per annum, are in many cases lower than the IRA security fee. You don’t have to be a mathematician to understand the effect on your savings.
Rolling your savings into your new employer plan each time you start a new job prevents your savings from ending up in a safe haven IRA. In addition, this year’s New England Pension Consultants Defined Contribution Plans and Fees Survey found that 88% of defined contribution plans use target date funds, which can generate income compounded by 5% at 7% per annum, as default investment alternatives.
That’s the compounding miracle in action – but you can only experience the miracle if you 1) never cash out and 2) consolidate your savings into your current employer’s plan each time you change jobs.
Spencer Williams is President and CEO ofRetirement Information Centera provider of portability solutions.