Barbara O’Neill, Ph.D., CFP®
Extension Specialist in Financial Resource Management
Rutgers Cooperative Extension
Want to convince someone to save money for emergencies (e.g., unemployment or car repairs) or to achieve future financial goals (e.g., a certain nest egg for a child’s college education or retirement)? Teach them about the time value of money and the awesome impact of compound interest upon the growth of savings over time. This was the conclusion of a study reported in the October 2011 issue of the American Association of Individual Investors’ AAII Journal in an article called “Understanding the Impact of Compounding Increases Savings Rates.”
The reported study included samples of college students and employees of a Fortune 100 company. It found that many respondents did not understand the exponential growth of compound interest or the cost of delaying saving for retirement. Respondents severely underestimated the size of an account balance after a period of 40 years of growth. The median estimate of the amount that an account balance’s size would be was less than 10% of what it would have been at a specified rate of return. That’s right: just 10% of the actual amount!
Stated another way, many people are not aware of how even small amounts of money can grow to significant sums given three, four, or five decades of growth. Compound interest is the process of earning interest on interest, i.e., interest not just on the original amount invested (principal), but on all the previously earned interest as well. It has been called “the eighth wonder of the world” by some but is unfortunately not well understood by many.
The AAII Journal article also reported that many of the respondents incorrectly assumed that it is easy to make up for lost time by saving more money later. Unfortunately, they were wrong about this as well. Financial planners like to say that “compound interest is not retroactive.” In other words, you can’t earn interest on money that was not previously saved. The reality is that, for every decade that someone delays saving for a future financial goal, such as a certain amount of money at retirement, the amount required to save annually approximately triples. Here’s an example: if you want to have $1 million accumulated at age 65, you’ll need to save the following amounts annually: $2,259 at age 25, $6,079 at age 35, $17,460 at age 45, and $62,745 at age 55 assuming a 10% average annual stock-based return.
There was some positive news. The researchers also found that employees who were shown the estimated amount in their 401(k) plan account at retirement were motivated to increase their savings. According to the AAII Journal, “the authors found that even when the ending balance was larger than needed, participants still wanted to increase their savings.” Their conclusion: by being shown the dollar-value impact of compound interest on a sum of money over time, individuals can be motivated to save.
Want to know how your money can grow and, perhaps be motivated to save more like the participants in the study? Online calculators that do compound interest calculations are plentiful.Simply input values for the amount saved, annual savings additions (e.g., payroll deposits into your 401(k) plan), the number of years that money will grow, and an assumed interest rate. The Internet calculator will do the rest.
This study shows that “knowledge is power.” People make better decisions and take positive actions when they thoroughly understand an issue. Whether it is knowledge about how much money can grow to or the calorie counts on meals at a restaurant, which are now required in some locations, we tend to think twice about what we do (or don’t do) when we completely understand the facts.