Albert Einstein is rumored to have called compound interest “the most powerful force in the universe.” Whether he actually said it or not is irrelevant. People would be well served to act as if he did.
That’s the advice from Robert R. Johnson, president and CEO of the American College of Financial Services in Bryn Mawr, Pennsylvania and the co-author of “Investment Banking for Dummies” (Wiley, 2014).
Johnson provides this example:
“If a 35-year-old starts saving for retirement and puts $439 monthly into an account earning 10 percent annually, she will have accumulated $1 million by age 65. She will have made $158,040 in contributions and will have earned over $842,000 in compound interest. If that same individual waits until age 45 to start, she would have to up the monthly contribution to $1,306. She will have made payments totaling $313,440 and will have earned $686,560 in interest,” Johnson says.
While the 10 percent assumption may sound aggressive, Johnson says, since 1926, a diversified portfolio of large capitalization stocks has had an average annual return in excess of 10 percent.
Starting early is truly the key for building a secure retirement, Johnson says.
Another powerful tool is time, says Peter Lazaroff, wealth manager and director of investment research at Plancorp, LLC, in St. Louis, Missouri.
“Anyone that is turning away from stocks in favor of start-up investments and crowdfunding is taking on significantly more risk than a traditional stock and bond portfolio,” Lazaroff says. ”Time is the most powerful tool in finance, and leveraging the compound returns of a traditional stock and bond portfolio is the surest way towards financial success. It’s not particularly sexy, but good investments usually aren’t. Good investing is about hitting singles and taking walks. People who try to hit home runs will strike out more often than not.”
And while many people put saving for retirement last on the list of priorities because it is so far off in the future, it should be first on the list, Johnson adds.
“They first want to save for kids’ education, down payment for a home or home improvements, pay off credit cards, etc.,” Johnson says. ”For instance, they say ‘nothing is more important than my child’s education.’ There are many options for a child’s education – student loans, going to a less expensive state school, etc. Once someone hits retirement and hasn’t saved enough, the options are unattractive – work longer and/or scale back on your lifestyle.”
Even when there are employer-sponsored opportunities to save for retirement, many people do not take them.
“The 25th annual Retirement Confidence Survey completed in 2015 by the Employee Benefit Research Institute showed that 71 percent of all workers had some type of retirement program offered by their employer, but that only 40 percent of them made contribution to these plans even when an employer match was available,” noted Keith Baker, a mortgage banking professor at North Lake College in Irving, Texas.
Given the importance of time, prioritizing and the power of compound interest, just how should a person in her 30s or 40s save for and invest their money to have $1 million awaiting them for retirement? Johnson, Lazaroff and Baker provide seven tips for that seven-figure investment plan below:
1. Get Professional Help
“Crafting and carrying out a retirement income plan is difficult,” Johnson says. “People should establish a relationship with a financial advisor to help guide them through the complex retirement landscape.” Johnson suggests seeking trusted advisors holding a well-respected financial credential such as the Chartered Financial Consultant (ChFC), Certified Financial Professional (CFP) or Retirement Income Certified Professional (RICP) designations. Lazaroff suggests that people only work with a financial advisor that is a fiduciary and regulated by the SEC: “If they aren’t regulated by the SEC, then the advice they provide is held to weaker standard that allows them to sell products that may not truly be in your best interest.”
2. Perform a Spending Plan
“Start by keeping a log of what your cash outflows are in detail for 2 months,” Baker says. “Have a goal of reducing less than necessary spending to save an additional $400 per month. At a 7 percent return this would create $516 627 by age 65 if you started at age 30 or $1,030,589 if you had an employer that would match your $400 per month.”
3. Don’t Spend Your Raises, Save Them
A recent Mercer study has shown that the average raise over the past 5 years has been around 2.8 percent, Baker says. This would translate into an additional $150 per month in savings if you put it into an IRA or as an additional contribution to a 401(k) plan. Take $150 of each subsequent raise and add it to the original $150. This compounded over a 25 year period from age 40 to 65 at a 7 percent return would be $1,096,462 starting off saving $1,800 in year 1 and $45,000 in year 25.
4. Examine Your Housing Cost Profile
Many individuals have not moved into the most cost effective housing. Says Baker: “I am not advocating for the ‘Tiny House Nation’, but smaller energy efficient housing closer to work can allow additional funding for retirement. Just because you can qualify for a mortgage when your housing to income ratio is 28 percent and you make $100,000, it doesn’t follow that you should be spending $28,000 a year on you home payments. If you could reduce your housing cost by $11,000 a year at age 35 and save the difference in an IRA or 401(k) at 7 percent, you would have $1,078,063 by age 65.”
5. Be Brave
Don’t be conservative when setting your asset allocation, Johnson suggests: “Time is your greatest ally when you are attempting to accumulate wealth. Over the long run, stocks have beaten bonds in performance over every 20 and 30 year period in US history. While that isn’t guaranteed to happen in all time periods in the future, the odds are overwhelmingly in your favor.”
6. Stay Invested Through Both Good and Bad Markets
“Time and compound interest will reward you for your patience,” Lazaroff says.
7. Take Full Advantage of Tax Deferred Accounts
“The only thing better than compound interest is compound interest without taxes,” Lazaroff says. ”Taxes shrink your return, so try to contribute the maximum allowable amount to company retirement plans and IRAs. - Sioux City Journal
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