By Adam K. Wright, CFA®, CFP®
A major tool when it comes to retirement planning is your investment portfolio. When planning for the long term, taking advantage of investments that compound can benefit anyone looking to grow their funds for a successful retirement. Even if your investment period is for a shorter duration, compounding can still work for you—though it’s over long periods that compounding really adds up!
Savvy investors understand that the benefits of compound interest are rooted in the concept of the time value of money, meaning that a dollar today is worth more now than it will be worth in a few years. When you invest well, and stay the course for the long term, the effects of compound interest can create very large nest eggs for retirement. However, most of the growth happens at the end. For instance, did you know that most of Warren Buffett’s $90 billion net worth occurred after he turned 65? Let’s take a deeper look at what compound interest is, and how to use it to benefit your retirement plans.
What Is Compound Interest?
Compound interest means that an investor will earn interest on both the initial investment and all the re-invested interest the investor earns from their investment. This amount can multiply at an accelerating rate and create much more money than the original amount invested. So, how does it work?
If you take $1,000 and invest it in an account that earns a compounded rate of return of 10% per year, then after 1 year, your initial investment increases to $1,100. The next year, you earn 10% interest on $1,100, increasing the amount to $1,210. Such that over 30 years, your initial $1,000 turns into $17,500. In fact, at 10% annual returns, your investments can be expected to double in 7 years. Think about that for a 55-year-old planning for retirement. They may have $2,000,000 saved up now, but at age 62, when they’re ready for retirement, they’ll have $4,000,000. And that’s without any more savings!
Thanks to compound interest and its wonderful effects, someone who was a good saver early in their career can sit back and let their investments do all the work. Compound interest has taken over and will grow retirement funds for you!
Key Factors to Consider
There are several key elements of compound interest that will make a difference in the amount you accumulate for your retirement. First, the higher your rate of return, the higher the ending value. Average rates of return can vary, but a reasonable estimate for retirement accounts is between 5% and 10%. As tempting as the higher rate of return may be, remember that, in general, the higher the return, the riskier the investment. Though you have the potential to earn 10%, per year, you also have the potential to lose just as much, if not more. So far, 2022 has reminded us that return and risk are inextricably intertwined.
Second, the more time you have to let your retirement investments grow, the bigger your nest egg will become. It’s okay if you don’t have thousands to save and invest every year. Even putting away a dollar a day when you’re young can pay off big in the end. Time is a best friend to those trying to earn compounded returns. It’s never too late or too early to start.
Another key element to consider is the frequency and how much you save. For example, let’s assume your retirement calls for you to have $1,000,000 in 30 years on the day you’ve marked for your retirement. To hit this mark, let’s further assume a 7.0% rate of return. There are two ways to hit your $1,000,000 goal. One is to save over time, and the other is to invest a lump sum today. Since many don’t have $130,000 laying around as a lump sum, they need to save over time, usually monthly. Saving $833 per month, or $10,000 per year, at 7.0% will meet your $1,000,000 goal in 30 years. Amazingly, due to the effects of time, your first $100,000 saved will grow to make up nearly 60% of your final nest egg. This tells us that saving frequently and saving early helps contribute to a comfortable retirement!
A final consideration is the effect of taxes. Taxes are a form of return drag. It is best to defer or avoid taxes for as long as possible. For instance, saving and investing inside a 401(k) will defer taxes until withdrawal. By deferring taxes, you leave more invested in the market to help grow your retirement nest egg.
Tools to Help
If you want to learn more about putting compound interest to work in your retirement, there are many resources online to help, like the U.S. Securities and Exchange Commission Compound Interest Calculator. It can also be instructive to run what-if scenarios. Financial independence and a successful retirement is in reach for almost everyone. Just make sure you have compounding working for you, not against you!
At Wright Associates, helping you build a reliable retirement plan that gets you from here to there is precisely what we do—and we love every second of it. Schedule a complimentary phone call to get started.
Adam Wright is a CERTIFIED FINANCIAL PLANNER™ professional at Wright Associates, helping clients plan and prepare their investments to retire on their terms. If you’re serious about planning for your retirement and investing for your future, his annual process will help you make the right money choices today. Therefore, Adam and his team will proactively manage your accounts while communicating the progress of your financial plans. He believes the retirement advice you receive should be intentional and actionable.
Adam has a Bachelor of Science in Supply Chain and Information Systems from The Pennsylvania State University and a Master of Business Administration from University of Pittsburgh, Katz Graduate School of Business. He lives in Upper St. Clair with his wife and two children. When he’s not working, Adam enjoys the outdoors (fly fishing), reading, and taking long runs while listening to a favorite podcast. He’s also currently encouraging himself to take up golf. To learn more about Adam, connect with him on LinkedIn.