A question that’s been coming up with clients in their 30s and 40s lately is, “I keep hearing so much about compound interest, and I’ve been saving extra for years, but I don’t actually see the compound growth yet, what’s going on? When can I actually retire?”
I get it, saving means that we’re giving up some of our “current self” needs. Perhaps we’re saving instead of doing something else and we want to see the results right now. This is what makes saving for future self so hard. 1) It’s really hard to conceive of ourselves in the future tense, and 2) It’s especially hard if that future we want is decades away.
So let’s go over what to expect when you’re saving extra hoping to put your future self in a much better situation either to have options to walk back to part time work leading up to retirement, retire at a normal age (or even early), or not be so reliant on a day-job for your income streams at some point.
The Rule of 72
This is a good short-cut rule to have in mind when you’re thinking about your extra savings and for setting expectations on what growth in your assets will look like over time.
This formula estimates how long it will take for an investment balance to double in value. I think most people can agree that doubling your balance is a good way to “feel” the value of compounding interest.
72 divided by the Expected Average Interest Rate on Your Investments = Number of Years required to double your balance.
Let’s say you invested $10,000 in one year and the expected annual rate of return is about 7%. 72 divided by 7 = 10.2 years. It will roughly take about 10 years to see that $10,000 balance double to $20,000.
Say you invested $10,000 each year for 5 years and then stopped investing new money. That means it would take 10 years for the first year’s investment to double, 10 years for the next year’s to double and so forth. By year 12 only some of your original investment will have doubled. It will take 14-15 years to see the entire balance double according to the rule of 72.
Here’s what that looks like in a chart: The blue shows the original investment while the orange shows the growth of the investment (aka the compounding).
Example 1: Investing a Lump Sum and Seeing How Long it Takes to Double Over a 15 year Time Period
So, what does this show? The rule of 72 means it’s going to take quite a few years before we start “seeing” or “feeling” the true value of compound growth. Even after 7 years, when you worked so hard to invest that $50,000 over the initial 5 years, you will have earned about $6,000-$7,000 of interest. It might feel small compared to your savings, but give it time.
By Year 11 and 12, the value of your earnings (in orange) start to look pretty nice coming in at between $30,000 to $40,000.
The compounding happens, but it’s way worse than waiting for paint to dry. It takes years and years to truly start seeing the compounding. But once it happens, it keeps going exponentially.
Retirement Savings Compounding
Now let’s look at what this looks like over an entire 40-year career. The money we save in our 20s has time to double 4 times! The money we save in our 30s has time to double 3 times. The money we save in our 40s only doubles twice. And if we wait to save when we’re more financially stable in our 50s, then that money only has time to double one time.
For comparison to the example above, let’s say you save a minimum amount of money annually — a few thousand dollars — each year in your 20s. You start increasing your annual retirement savings to more than $10,000 per year in your 30s, and before you turn 40 you start maxing out your retirement contributions according to the IRS maximum (The current IRS maximum is $19,500 for under 50 and $26,000 for over 50). This is a stylized few of what your account will be worth in a snapshot once every 5 years.
If you’re interested in going for early retirement, you’re probably going to need to save more than the federal maximum in order to have enough money to live comfortably (unless you plan to live in a very low cost area or find other ways of cutting your expenses in retirement). But for comparison let’s look at a normal retirement at age 65.
Example 2: How Compounding Works When You Invest New Money For Retirement Each Year
It really does take a long time to “feel” the compounding show up. But stick with it, the compounding is coming! By age 65 much of what you had saved early on has doubled several times.
By Age 65, your nest egg has grown to more than $2.8 million. This will provide you with more than $110,000 of pre-tax income per year (in current dollars). You can increase the amount you take out of your portfolio by inflation every year. That means that in your 60s you’re taking out between $110,000 to $130,000 per year, but in your 80s you get closer to taking out around $200,000 per year.
In fact, the compounding of your retirement balance doesn’t stop once you retire. If you remain invested appropriately (investments get more conservative as you age) and you use the best available research to draw your assets to withstand natural stock market changes, your balance will keep growing for another decade or so after retirement.
Then your balance will slowly draw down, and you’re left with a nice nest egg of about $1,000,0000, which could be used for end-of-life care in a nursing facility and/or perhaps provide your family with a nice inheritance if long-term care services aren’t needed.
Example 3: When Drawing Down Assets in Retirement, Your Balance Keeps Growing for a Decade After Retirement
Looking at these stylized examples it’s much easier to understand that we can’t commit to normal or early retirement by saving a little bit here and there. It takes a plan and it takes checking in with your plan. It’s also going to take more than a few years to start truly seeing your progress.
This is one of the reasons why sticking with an investment plan on your own can be so challenging. If we don’t see results quickly we can be tempted to make changes to our investments. But when we constantly change our investments we’re going against the right way to invest, which is to set up a plan and then let it run in the background, taking care to only adjust so that our investments stick with our original plan. Consider working with a CERTIFIED FINANCIAL PLANNER® to help keep you on course.
What do you think? Have you ever made changes to your investments because you felt like you weren’t seeing enough progress? What was the outcome?