Compounding is the mathematical phenomenon that drives the exponential growth of your savings if you keep reinvesting your returns.
With ‘exponential’ growth, the rate of return on your initial capital keeps growing, even if you earn the same rate of return on your investments year after year. That’s because you don’t just earn the return on your capital, but also on all the returns you have reinvested.
The longer you leave your returns to compound, the more dramatic the exponential growth will be. The effect is much like that of a snowball rolling down a hill: the bigger the snowball gets, the more snow it packs on with each revolution.
Warren Buffett, who turns 89 this year, is widely seen as the most successful investor of modern times. He accrued more than 98% of his wealth after his 56th birthday, but it needed the foundation he laid in the 30-odd years before then.
Warren Buffett: “My wealth has come from a combination of living in America, some lucky genes, and compound interest.”
Smart investors copy what they can of the Sage of Omaha’s recipe for success.
The decisive input in a simple compound interest formula is time. The more time you give your principal investment to compound, the more dramatic the exponential returns. Even modest monthly contributions can grow into a material amount – if you give it enough time. Which is why it is so important to start saving for retirement as early as possible.
The earlier you start to save for retirement, the longer your money has, to work for you.
Early on, the return component is just a tiny fraction of your total savings, and it takes quite a few years to become significant. In Figure 1, returns equal contributions only at around age 50, after 25 years of saving and investing. However, at the end of the period (only 15 years later) returns are more than double contributions.
The point is, it takes some time for compounding to become a powerful force. The big acceleration happens after around 20 years.
For example, say you earn a total real (after-inflation) return of 4% per annum (net of fees of 1% pa) on your annual contribution to your retirement fund. After 10 years, returns will equal roughly 32% of your total contributions, after 20 years that will be 74%, after 30 years 132%, and after 40 years 217%.
The bottom line is this: give your savings enough time earning returns on returns and your nest egg will grow into a significant number, one that might have seemed totally out of reach when you started.
Small fee savings, huge investment gains
The power of compounding grows with the rate of return. Over the long term, small differences in the rate of return make a huge difference to your savings outcome. That’s why investment costs matter so much. Whatever the rate of return, saving on your fee rate, even just 1% per annum, compounds into a whole lot more money at retirement, and can be the difference between a comfortable and a cash-strapped retirement. In numbers, paying 1% less in fees per annum over a diligent 40-year savings period would mean 30% more money when you retire.
More compounding magic: the first dozen years of saving fund half your retirement!
Here’s another way to look at the power of compounding: in a diligent 40-year savings plan, the first two years’ contributions will pay for 10% of your retirement. By the time you hit 35 (after 11 years of saving), you have already funded almost half your pension. By contrast, the last 10 years’ contributions make up only 10% of your pension.
Time really is money in the context of compounding returns. If you leave it too late, it becomes very difficult to make up the shortfall. You should save like crazy early on, because those savings will work the hardest for you. If you want to skip 10 years of saving, skip the final 10 years of your working life, definitely not the first 10.
The corollary: you need to preserve your savings
Once you see how much your early savings contribute to your final retirement pot, you will appreciate how short-sighted it is to cash in those savings when you change jobs. Yet this is what 70% to 80% of employees do when they leave their employer.
This behaviour is partly borne out of ignorance because people believe they have time to play catch up. But to do so, they would have to work much longer, or save much more, to make up the shortfall.
To illustrate, the example in Figure 3 shows different scenarios for someone who is investing R1,000 per month (growing at 1% pa) for 40 years, earning a net real return of 5% pa. If this programme is followed for 40 years the saving would grow to R1,7m. Cashing out after 10 years, and starting over would reduce the payout to R901k (47% less). Cashing out after 20 years, and starting over, means a retirement savings pot of only 25% of what it could have been.
This is (the lack of) compounding working against you. To make up the ‘10-year’ shortfall, you would have to save twice as much thereafter every month; to make up the ’20-year’ shortfall, you would have to save four times as much!
So instead of cashing in, rather exercise the option to transfer your retirement savings tax-free to your new employer’s fund or to a preservation fund. By preserving your savings, you not only preserve all the tax benefits, but also all the future returns on that money that you would otherwise forego, and ultimately, the lifestyle that you wish to retain into retirement.
For more information about preserving your savings download the free e-book.