Just
contributing to your retirement savings is
not enough. You’ve got to make them earn
decent returns so their compounding effects
significantly add to what you eventually
accumulate. To settle for pathetic
investment earnings makes saving for
retirement only a contribution game with
meagre results. This article shows the kind
of earnings you need to compound your way to
a decent retirement.
Government-regulated retirement programs,
like your 401(k), 403(b) or IRA are geared
to help you save for retirement. Though
their annual contributions are limited,
they’re deductible from you working income.
This helps you contribute more to your
savings than using after-tax dollars. Their
tax-deferred growth allows all your earnings
to contribute to the compound rate of your
savings without any loss annually to income
taxes.
I’ve
constructed an example to show how important
it is to get decent earnings on your
investments to accumulate significantly more
and to make your earlier contributions pay
off.
Let’s consider that you have 40 years over
which you can contribute and grow your
money. But there are two different
contribution options by which you can choose
to contribute. The first option is that you
contribute just $1,000 (i.e. $1K) to your
savings every year for the first 10 years.
But then you don’t contribute any more for
the remaining 40 years; you just let your 10
years of contributions grow by its
investment earnings. Your total contribution
under this scenario is $10K. Let’s call
this option the ‘$10K early’.
The
second option is that you forego any
contribution for the first 10 years, but
then contribute $1K per year every year for
the last 30 years. Of course these
contributions will grow also by their
investment earnings, too. Your total
contribution in this second option is $30K –
three times as much as in the first option.
Let’s call this option the ‘$30K late’.
Now,
let’s compare the resulting accumulations
after 40 years for both these options for
different compounding rates. The compound
rate is that amount of investment earnings
annually left in your savings to grow- not
lost to taxes or fees. A 4% earnings rate
that lost 25% of the earnings to taxes would
compound at 3%. A 4% tax-deferred earnings
rate has a 4% compound rate.
4% compound rate accumulations:
After 40 years at a 4% compound rate, the
‘$10K early’ accumulates to $40K (4 times
what was contributed), while the ‘$30K late’
accumulates to $58K (about 2 times what was
contributed). So you ended up more with the
late contribution option – but of course you
contributed 3 times as much.
6.3% compound rate accumulations:
After 40 years at a 6.3% compound rate, both
contribution options accumulate to $88K.
This compound rate was chosen to produce
this result. Clearly, as earning rate
increases so do your accumulations. But now
those early contributions earn far more: 9
times more than the $10K early contribution,
and only 3 times more than the $30K late
contribution.
8% compound rate accumulations:
After 40 years at an 8% compound rate, the
$10K early contributions accumulated to
$157K while the $30K late option accumulated
only to $122K. Again, increased earnings
accumulate more. But now your investment
earnings are contributing a greater share to
your accumulations.
The
magic of compounding is making those early
contributions win out over larger later
contributions. Comparing final
accumulations, the $10K early option
achieved almost 16 times contributions
versus a little more than 4 times
contributions for the $30K late option.
Higher earnings not only produce higher
accumulation amounts but a huge difference
for when the contributions are made.
Learn to make your savings work hard:
Recognize first that getting higher earnings
rates significantly enhances your final
accumulation no matter when you contribute
over a long time. But, second, they make
those early contributions work hard at
earning much more than later contributions.
Many
people waste their savings in low earning
savings vehicles. They play it too safe or
pay too many fees – or both. Though they
worked hard to contribute to their savings,
they dropped the ball on making those
contributions do their share of earning.
You
should be able to get your investment
earnings over 6% at least – and ideally up
to 8% - and more. These growth earnings are
below the average for stocks over 80 years
(1926-2006) as shown by Ibbotson Associates.
So I
emphasize that there are 2 parts to
achieving independence– one is not enough:
o
Contributions
o
Investment earnings
Contribute to your savings – starting as
early as possible – so you can also get the
benefit brought by decent earnings. Then
work at getting earnings of 8% or more.
Learn to make your savings work as hard as
you do.
