“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.” - Albert Einstein
We recently came across a study conducted by Bankrate.com which concluded that roughly 10% of the US workforce isn’t saving a single penny toward their retirement. Additionally, of those that were saving, 14% reported they were saving less this year versus last year. And not surprisingly, the younger the worker, the less likely they were to be saving for retirement. Unfortunately our education system and spendthrift society do a very poor job emphasizing the importance of saving at a young age in order to harness the full potential of what Albert Einstein considered to be the 8th wonder of the world. In this week’s Insight we will unpack the miracle of compound interest to hopefully encourage our readers to save early and often.
Many working Americans feel that they can’t afford to be saving for retirement because they have to worry about their expenses in the here and now. For some individuals and families this is probably a true statement, but for many of us, it is just an excuse to justify our laziness. What if I were to tell you that by forgoing the purchase of restaurant coffee (including Starbucks and the like) and saving the money starting at age 18, the average American worker could retire at age 70 with over a million dollar nest egg. Would you believe me? According to the Consumerist, the average American worker spent close to $1,100 a year on coffee back in 2012. If instead of spending this amount it were saved in an IRA account where it could grow tax free at an assumed rate of 8% a year starting at age 18, the account would be worth just over $1.1 million by the time our theoretical person turned 70.*
We use the coffee example as a simple illustration of how saving at an early age can make a huge difference in retirement. From the chart above we see that the miracle portion of the compound interest effect really comes into play toward the end of the plotted time horizon. For example, 50% of the total $1,011,180 return on investment (money earned above what has been deposited) at age 70 was earned in the last seven years from age 63 – 70.
The hockey stick like growth of the account in the latter years is the visual representation of the 8th wonder at work. The power of compound interest comes from generating returns on reinvested returns. By age 63 our investor has deposited a grand total of $81,764 into their account which has generated an additional return of just over $550k. The following year, their invested capital base of roughly $81k will only earn them around $6,500, but their re-invested returns of $550k will earn them an additional $44,000 for a total account level return of just over $50,000.
The chart below shows the percentage of each year’s return that is coming from the reinvested returns versus the invested capital base. At the onset, obviously the money being deposited into the account is doing the heavy lifting and accounts for the vast majority of the total returns being generated inside the account. But after 18 years of consistent savings and reinvestment, the reinvested return outweighs (greater than 50%) the returns being generated on the deposited capital. By the time our investor turns 70, over 90% of the annual return in the account is coming from reinvested capital versus less than 10% from the deposited capital base.
The reason the miracle of compound interest is so prolific in our example is due to the rather long time horizon (52 years). If for example, we assume someone doesn’t start saving their coffee budget (or something of an equivalent amount) until age 35, the numbers look quite different. The ending account value in this scenario drops from over $1.1 million down to just over $385,000. In order to catch up to our original analysis and retire at age 70 with a $1.1 million nest egg, the investor who starts at age 35 would need to save three times as much per year as our original investor. In other words, the late investor will end up having to save an extra $190,000** by the time they turn 70 to arrive at the same retirement goal as the investor who starts early.
Another reason the compounding effect in our original example is so powerful is due to the consistent commitment of our investor to sock away the money every year without tapping into the funds. As another example, let’s say our same investor who starts saving his/her coffee budget at 18 decides to tap their account for a $10,000 luxury expense at age 25 and again at age 30. Under this scenario, the ending account value at age 70 is more than cut in half to around $530,000. In other words, the two choices to take a total of $20,000 out of the savings account within the first 12 years ends up costing our investor over half a million dollars in ending account value at age 70.
We use these simple examples to illustrate the power of compound interest as it applies to a consistent saver who starts at an early age. For those readers who still have children living at home, we encourage you to teach/drill these lessons into your children so that they might be afforded the opportunity to fully harness the 8th wonder of the world and thereby make it easier for them to save for retirement in their later years. With proper education we might be able to change the course of the next generation so that they don’t fall into the same trap many of the younger workers from the opening study find themselves in today.
* The price of coffee was also inflated by 2% a year.
** Does not account for the time value of money.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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