Building up a big enough nest egg for retirement is a goal for most people. The amount of savings you have available when you retire is a function of three things:
Time – When you start saving. The earlier you start the better.
Investment Return – The amount of money your savings earn. Usually this comes from interest, dividends, and capital gains.
Savings Amount – How much you save per month or year.
One could make the argument that Time is probably the biggest factor to how much money you have available for retirement. The main reason Time has such a positive impact on your savings is because of the concept of compound interest.
Compounding is the process of generating earnings on an asset’s reinvested earnings. To work, it requires two things: the re-investment of earnings and time. The more time you give your investments, the more you are able to accelerate the income potential of your original investment, which takes the pressure off of you.
To demonstrate, let’s look at an example:
If you invest $10,000 today at 7%, you will have $10,700 in one year ($10,000 x 1.07). Now let’s say that rather than withdraw the $700 gained from interest, you keep it in there for another year. If you continue to earn the same rate of 7%, your investment will grow to $11,449.00 ($10,700 x 1.07) by the end of the second year.
Because you reinvested that $700, it works together with the original investment, earning you $749, which is $49 more than the previous year. This little bit extra may seem like peanuts now, but let’s not forget that you didn’t have to lift a finger to earn that $49. More importantly, this $49 also has the capacity to earn interest. After the next year, your investment will be worth $12,250.43 ($11,449 x 1.07). This time you earned $801.43, which is $101.43 more interest than the first year. This increase in the amount made each year is compounding in action: interest earning interest on interest and so on. This will continue as long as you keep reinvesting and earning interest.
Let’s look at a couple of examples on how compounding affects retirement savings. We will keep the return and savings constant in the three examples and show how starting to save at different ages impacts what you have available when you retire at 65.
I save $1,000 a month and earn a 7% return on my investments.
If I start saving when I’m 25 I will end up with $1,500,000 which I can convert into an income stream of $80,000 a year from age 65 to 90.
If I start when I’m 35, I will end up with $855,000 which I can convert into an income stream of $43,000 a year from age 65 to 90
If I wait 10 more years and don’t start saving until I am 45, I will end up $418,000 which could generate $21,000 in income a year.
For every 10 years that you wait after age 25 to start saving you are basically left with half of the amount of money when you retire. When you are in your twenties and early thirties thinking about retirement is often not on the forefront of people’s mind, but it is the best time to start saving for it.
Time Is On Your Side
