Compound interest

Compound interest and retirement savings

compound interest

The sooner you start saving, the better off you are.

JP Morgan Fund


As 2014 draws to a close, many people are gearing up to commit to their 2015 New Years Resolutions.

We have a resolution for every person in their twenties in America who isn’t saving for retirement: start saving now.

Because, every day that you wait to start saving, the difficulty of reaching your retirement goals literally gets worse. Literally.

Your parents had it easier

In the good old days, young Americans would go to work for an employer that promised them a comfortable retirement in the form of a pension plan, that is, a defined benefit plan.

Today, it is increasingly the worker’s responsibility to put money aside for retirement in the form of a 401 (k) plan or an IRA, that is, a plan to defined contributions.

The purpose of this article is not to explain the mechanics of pension plans. Rather, we want to show you the importance of starting to save as soon as possible.

Compound interest is power

It all comes down to an elementary mathematical principle:


compound interest

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Compound interest occurs when the interest that accumulates on a sum of money accumulates on its own. It is the strength of deceptive simplicity that quickly snowballs wealth. This is why it is the concept that is at the heart of all finance.

JPMorgan Asset Management employees demonstrate the true power of compound interest in their “Guide to Retirement 2014”.

Their example consists of three people who get the same annual return on their retirement funds:

  • Susan, who invests $ 5,000 a year only aged 25 to 35 (10 years).
  • Bill, who also invests $ 5,000 a year, but ages 35 to 65 (30).
  • And Chris, who also invests $ 5,000 a year, but aged 25 to 65 (40).

Intuitively, it makes sense that Chris ended up with the most money. But the amount he saved is astronomically larger than the amount Susan or Bill saved.

Interestingly, Susan, who saved for just 10 years, has more wealth than Bill, who saved for 30 years.

This difference is explained by compound interest.

You see, all the ROIs Susan has earned in her 10 years of savings are snowballing – a big time. These returns accumulate to the point that Bill cannot 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 equals Bill and Susan’s savings combined.

The longer you wait to start saving for retirement, the more you miss out on the incredible power of compound interest.

Here is the chart, in slide form, from JP Morgan Asset Management.

retirement


JP Morgan Asset Management


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