By Peter Kelly, Retirement Strategies and Solutions
(Prepare for Life)
Albert Einstein once said:
“Compound interest is the eighth wonder of the world. He who understands it, earns it… He who doesn’t, pays it…”
When saving for a long-term goal, such as retirement, is it better to save small amounts for a long time, perhaps saving when we can ill-afford to? Or, are we better off waiting until later and putting larger amounts aside when it is more affordable?
This question has plagued society for decades.
So, let’s look at both sides of the debate and put some simple figures together.
At the outset, some ground rules:
- The rate of return used is after deducting fees, tax, and charges
- All projections are expressed in 2019 dollars
- Inflation has not been However, this can be managed by increasing the amounts saved in line with inflation
Option 1 – Saving $100 per week for 40 years.
We start saving $100 per week, from age 25 through to age 65. We earn 5% per annum on our savings.
Over this period, our savings will grow1 to $661,275 over the 40-year period.
We have saved $208,000. But, our regular savings have earned $453,275 – more than double our contribution.
Option 2 – Saving $200 per week for 20 years.
In this option, we save $200 per week, but don’t start until age 45, also saving through to age 65, and earning 5% per annum.
In this instance, the amount saved will also be $208,000. However, by starting later, the earnings are only $148,229, making a total of $356,229 after 20 years.
To achieve the same outcome as Option 1, we would need to save $371 per week for 20 years, from age 45.
What if we earn 10% per annum instead of the 5% per annum in the above equations? And is 10% per annum a reasonable interest rate to consider?
Impact of interest
Between 1900 and 2017, the All Ordinaries Index of the Australian Stock Exchange returned an average of 13.2% per annum. The highest return of 66.8% was achieved in 1983, and the lowest return -40.4% was in 2008. In fact, of the 117-year period, 96 years returned a positive result and 22 years had a negative result2.
But let’s return to the results.
Option 3 – Saving $100 per week for 40 years, earning 10% per annum.
The total amount we have contributed is still only $208,000. However, the total amount saved jumps to a massive $2,740,434!
Sounds too good to be true, doesn’t it? Don’t worry, I ran the calculations a second time to check.
Option 4 – Saving $200 per week for 20 years, at 10% per annum.
With double the interest rate, saving more for a shorter period still only provides an accumulated savings of $658,120. This is still less than what you would receive in Option 1 where you saved $100 a week for 45 years at 5% per annum.
So, the verdict is in…… Saving a smaller amount for a longer period certainly seems to win out.
In the words of Albert Einstein, “Compound interest is eighth wonder of the world.”
1 ASIC MoneySmart Compound Interest Calculator – https://www.moneysmart.gov. au/tools-and-resources/calculators-and-apps/compound-interest-calculator