How Compound Interest Affects Retirement Funds

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, i.e. a defined contribution plan.

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

It all comes down to one elementary mathematical principle:

compound interest

.

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.

JP Morgan 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 per 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 the compound interest.

You see, all the ROIs Susan has earned in her 10 years of savings are snowballing – a big time. It’s to the point that Bill can’t catch up, even if he’s saving for another 20 years.

Of course, if Susan saved like Chris … well, if you haven’t noticed, Chris’s savings are just 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.

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

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