Most people have heard about the power of compound interest. Even world-renowned physicist, Albert Einstein had something to say on the matter. He called it the eighth wonder of the world. When it comes to long-term savings, like saving for retirement, compound interest can ensure anyone can live out their retirement years financially comfortable.
The problem however, when it comes to saving for retirement, is that people forget about compound interest and just how much it contributes to their savings lump sum when they get to retirement.
All too often, people save diligently for 20 years, and when they reach their late 30s or 40s, they cash in a portion of their pensions. They use this large lump-sum of money to pay off debt, buy a new car, renovate their home or invest in a holiday house at the beach.
What they don’t realise is, that by doing this, they have just set their retirement savings back to below zero. The reality is that because of compound interest, the future value of the money they are losing is substantial. An examination of the numbers just shows how much is being lost by not allowing pension investments to continue growing for another 20 to 30 years.
Let’s assume that we earn an annual interest rate of 8.5% on our investments. If, at the age of 20, you put R1 000 towards your retirement every month, by the time you are 45 years old your investment will have grown to over R1 036 255. During that time, your personal contribution would total R312 000. Compound interest would have contributed the remaining R823 255 to your lump sum.
If you keep that money invested and you carry on putting R1 000 per month away until age 65, your investment will grow to R5 877 906. Your personal contribution will total R552 000, and your compounded interest will equal R5 325 906.
However, if you decide to withdraw R1 million* at age 45, but you are still aiming for a R5.8 million lump sum at age 65, your savings regime will start to look very different.
You will need to invest R110 000 annually to save R5 821 417 by age 65. Your total investment over those years will be R2 310 000. Still, you are getting R3 773 797 from compound interest, but your total investment is 4.18 times greater than if you had let your savings be.
Gambling on good fortune
The reality is, that if we do not save conscientiously throughout our lives, saving for retirement can become increasingly expensive. The lumpsums required to kickstart our investments need to be increasingly larger. So, we end up banking on a lot of good fortune – inheritances, large bonuses, sudden business success, or maybe winning the jackpot.
Short-term prudence for long-term gain
The beauty of saving conscientiously throughout our lives, is that we do not need to be rich to do so. A person of simple means can end up being far more prosperous than their high-earning colleagues later on in life just by putting a little away each month.
By way of example, if we assume we have saved R1 000 every month during our work life, by the time we are ready to retire at age 65 we will have accumulated around R6 million. Given our 8.5% annual growth rate, a 6% annual inflation rate and a draw down rate of 4.7%, we can then expect, over the next 30 years, to receive a monthly income of R24 698. Even after tax, this would leave us quite comfortable in our latter years. Assuming our large debts, including cars and houses are paid off.
Ultimately slow and steady wins the retirement race – but we need to understand the impact of compound interest.