The Impact Of Compounding On Meeting Your Financial And Retirement Goals

Matt LaRocca |

Einstein is often attributed with the observation that compounding interest is the most powerful force in the universe: “he who understands it, earns it, and he who doesn’t, pays it.” Einstein’s supposed observation may be more urban myth than historical fact. But, there is no doubt that compounding interest and, on the flip side, compounding inflation are two important factors in determining whether investors meet their financial and retirement goals. This blog post focuses on the importance of not just saving but saving productively by creating a financial plan that uses compounding to your advantage.

More than five years after the beginning of the Great Recession, people remain wary of the stock market and investing in general. Investors in the ten biggest economies have pulled about $1.1 trillion from stock mutual funds in the past five years, opting instead to invest in U.S. treasuries and other fixed income investments paying near record low yields. Many others investors have decided to simply hold cash, fearful that the next financial crisis is around the corner.

One of the most risk adverse groups of investors is young people – even though they have the most to gain from investing in higher risk/higher reward assets. For example, one recent poll reveals that the number of people in their 20’s who own stocks has dropped about 20% since the Great Recession, with only 1 in 4 Millennials owning individual stocks or stock mutual funds. This same poll shows that even affluent Millennials have over 50% of their assets in cash. Clearly, the scars from the financial crisis have not faded and may not fade for years, especially for people who became adults during the Great Recession.

While cash and conservative fixed income investments undoubtedly play a role in a diversified investment portfolio, investors often ignore the effect of compounding inflation on these low yield investments. Inflation affects the cost of just about every asset – from food to clothes to cars to education. It is nearly invisible over the short term but increasingly eats away at each dollar we own as time passes. Simply saving money, without saving it productively, assures a loss in purchasing power over the long term.

A brief example will demonstrate just how damaging inflation can be. While inflation has been historically low in recent years (about 1.5%), inflation has averaged about 3.2% over the past century. Assuming inflation approaches more normal levels over the next several years, a 40 year-old planning on retiring at 65 can expect prices to have more than doubled by the time he or she retires. In other words, a 40 year-old who puts money in a savings account earning fractions of a penny will effectively have guaranteed a loss of about half of his or her purchasing power by age 65. If the retiree then lives until 90 without investing a dollar, his or her purchasing power will again be cut in half. Combining decreasing purchasing power with a lack of income and an extended life expectancy leads to financial difficulties for many retirees.

Compare this with an individual who invests, rather than simply saving money. Investing in the stock market has traditionally been the best way to beat inflation, with a historical real (after inflation) return of about 6% on average. So, a 40 year-old who invests in a diversified portfolio of stocks could realistically expect his or her money to quadruple by retirement, even without saving another penny. Even a more conservative investment portfolio (combining stocks and fixed income investments, for example) with a real return of 3% still results in a doubling of the initial investment by age 65. Of course, investing outside of savings accounts and low yield U.S. debt instruments comes with risk, but the alternative is to effectively lock in a loss after inflation is taken into account.

The issue then is not whether to invest before and during retirement, but how to do so. Each investor’s circumstances are unique, but there are a few important guidelines to keep in mind:

  • First and foremost, it is essential that everyone create a financial plan as soon as possible and revisit that plan at least annually. Establishing realistic financial goals and implementing a plan to reach those goals as early as possible are keys to a comfortable retirement. As the example above demonstrates, small investments can turn into much larger amounts given the benefit of compounding over time – just as cash that seemed sufficient once can ultimately fail to meet our future financial needs.
  • Second, formalize a budget, instead of saving only what’s left after expenses are paid. Maintaining a structured savings plan will encourage good financial habits and ultimately increase the likelihood of a successful retirement. For example, a common rule of thumb is that investors should have about 8 times their salary in savings by their mid 60’s. This requires saving about 10% of gross income per year throughout a person’s entire career, with this percentage increasing exponentially the longer one waits to begin saving. Putting a budget and savings plan in place as soon as possible can avoid unrealistic saving requirements later in life or a delayed retirement.
  • Third, the current economic environment makes it even more important to own investment assets, rather than rely solely on wage income for retirement. In the current environment, employers have little incentive to increase salaries at rates higher than inflation. With this in mind, the best way for many of us to grow our net worth is to invest as much of our salary as possible after non-discretionary expenses, instead of hoping for a salary raise in what is still a buyer/employer’s market.
  • Fourth, retirement accounts alone do not guarantee a safe retirement, but investors should try to take full advantage of any tax-advantaged accounts. While other financial obligations may make it difficult to contribute the maximum amounts (generally, $5,500 for IRAs/$17,500 for 401Ks), investors should try to contribute as much as possible to their retirement accounts. The compounding effect of a tax-deferred account is even more pronounced than in a taxable account. 529 Plans also are a good choice for families with children, as they offer a tax advantaged way to save for college, much like an IRA for education.
  • Finally, it is never too late to start planning for retirement. Investors of all ages should be constantly evaluating their financial goals and their plans to meet those goals. With life expectancies steadily increasing, retirements can stretch three decades or more. The key then is not just to put a financial plan in place, but to constantly update it throughout one’s life.

At RDM, we are able to help you with all of your financial and investment needs – whether you are just starting your career, approaching retirement or already retired.

Ultimately, each person will have a different financial and investment plan based on their own circumstances. As an independent investment adviser, we have the unique ability to work with each individual to create a plan that works for them. Please contact us if we can assist you with establishing your financial and investment goals and creating a plan to meet those goals, regardless of your stage in life.