When considering a subject to write about, I decided to ask one of my old college roommates what financial topic she wishes she’d known more about as a younger professional. Her response: Why should I make consistent, small contributions to a 401k – or other retirement account? And how does it build up over time?
What my friend was referring to is called the power of compounding. You may be more familiar with compound interest in terms of debt – if you don’t pay off your balance within a pre-determined term, most debtors start charging interest on the unpaid balance, and your total amount owed increases with time – yikes!
When it comes to savings, the power of compounding looks instead like positive growth – which means the amount of money in your account increases resulting from re-investing dividends and interest over time. It’s tempting, especially for young adults or lower-salaried professionals, to wait to invest until you feel like you have “more money,” but is that wise?
Let’s take a look at how small investments over time compare to waiting for more “cushion” in income.
Meet three fictional characters – Mary, Max and Carter. At age 25, they have just started their first “adult” jobs in Des Moines and are each renting an apartment while paying off student loans. All three young professionals have access to an employer-sponsored retirement plan at work that they can contribute to (and may have an employer match.)
Mary decided to save in her employer-sponsored retirement account and figures she can afford to put $5,000 into this account every year. Her investment averages a return of 7% per year, and she continues to save $5,000 each year for 10 years. Mary then decides to change jobs, and her new employer does not offer a company sponsored retirement plan. Now that her investments aren’t automatically scheduled through work, she forgets to set up a savings plan and leaves the $50,000 invested in that original account. When she retires at age 65, she checks her account and is surprised to see it has grown to $562,683!
As a recent graduate, Max decided to focus on paying off those pesky student loans first and hold off on retirement savings for ten years because he just didn’t have the cashflow. After celebrating his loan payoff, Max decides to invest $5,000 per year into a retirement plan. He sets it up and forgets about it. He doesn’t miss the money since he had been paying off his student loans until then, and he never makes changes to his contributions over the years. He also has an investment that averages 7% a year. When Max is set to retire at 65, he checks his account statement to see that his account is worth $505,365.
Carter, on the other hand, decides to start saving $5,000 a year right away like Mary, but he never quit. When Carter retires at age 65, he is excited to see that his investments had grown to $1,068, 048. Carter had only invested 10 more years than Max for a total of $50,000 more, but because of the power of compounding, Carter’s account was worth twice of Max’s.
|total amount invested||account value at 65|
|mary (saved for 10 years and stopped)||$50,000||$562,683|
|max (waited 10 years, then saved for 30 years)||$150,000||$505,365|
|carter (saved for 40 years)||$200,000||$1,068,048|
Even if you can’t afford to save much now, having more time for your investment of any amount to compound will be more beneficial than holding off to save. Even though Max saved three times more than Mary, his account was still worth $57,000 less than her account was at age 65 because he waited to start saving.
The moral of this fictional story? Save early and save often. Establishing a healthy habit of saving into a compounding account early is beneficial in several ways — not only can you reach your long-term financial goals, but even if (when?) life throws you a curve ball and you need to pause your savings plan, your saved investment continues to work for you.
Lindsey Taylor, MFM
Securities and Advisory Services offered through Harbour Investments, Inc. Member SIPC & FINRA.