Compounding interest helps pad nest egg
If you have only 10 years left before you retire, and you have only half of what you need, don’t worry, you still might be OK.
I met a 55-year-old couple the other day who wanted to retire at age 65. Let’s call them Stan and Tasha. In order to generate the income they desire at retirement, they need to have $1.2 million of income-generating retirement assets by the time they reach 65.
Stan was freaking out. “It took us 30 years to put away $600,000. How in the (colorful word) are we going to get another $600,000 in just 10 years?” Tasha looked on with true concern splashed all over her face. “I can put $20,000 per year away at the most, and that will only equal another $200,000 come retirement. Will I have to invest very aggressively now? Where’s the $400,000 coming from?”
Math, my man. Math!
I sure hope my middle school math teacher reads my column. I must have said “when are we ever going to use this?” a couple dozen times in seventh grade alone. Alas, math matters.
Stan and Tasha hadn’t put away $600,000 — they put away much, much less. By my estimation, Stan and Tasha have set aside only about $144,000 over the course of 30 years. Over the past 30 years, the Standard & Poor’s 500 index has averaged just over 11 percent per year. I highly doubt Stan and Tasha got 11 percent. My guess (and yes, it’s just a guess) is that they averaged about 8 percent annually. Which means roughly $456,000 of their $600,000 came from growth.
Stan and Tasha have committed to invest $20,000 per year for the next 10 years. That’s great. But the $600,000 they’ve already accumulated is still going to work hard for them over the next years, too. In fact, Stan and Tasha will need to achieve only a 4.6 percent average return to accomplish their $1.2 million retirement goal.
Welcome to the glory of compounding interest.
I first read about the power of compounding interest in George Clason’s classic “The Richest Man in Babylon,” published in 1926. When your money grows, the growth joins the original deposit, then both the growth and the original deposit grow. The longer your money has to grow, the more it can compound. Stan and Tasha are going to be able to retire because they started investing when they were 25 years old. Their earliest deposit will have been compounding for 40 years by the time they retire. Which means the first $100 they invested every year will be worth $29,091.73 alone (averaging 8 percent). While the last $29,091.73 they will deposit will grow to only about $32,000 by the time they retire.
There’s another fun math lesson that can help pre-retirees project their retirement nest egg. Ten years out from retirement, you will need to achieve only a 6.96 percent average annual return to double your money, without any additional deposits. In other words, you need only half of your retirement nest egg 10 years out from retirement. And as long as you’re making relatively hardy contributions to your account for those 10 years, you won’t even need to average 6.96 percent to double your money.
I know what you’re thinking: Couldn’t a stock market crash ruin everything? Yes and no. Yes, if you have an unbalanced portfolio filled with just stocks. No, if you are properly diversified across different asset classes, including stocks and bonds. People are surprised to learn that a 60 percent stock (S&P 500 index) and 40 percent bond (Barclays US Agg Bond Index) portfolio has outperformed a 100 percent stock portfolio based on 15-year average returns (period ending Dec. 31, 2015). Having a balanced portfolio heading into retirement certainly doesn’t guarantee against loss, but a balanced portfolio has historically softened the blow of a tough market.
My strategy for selecting risk-appropriate investments involves taking the least amount of risk necessary to accomplish the goal at hand. Stan and Tasha need to average only 4.6 percent per year. Therefore, Stan doesn’t need to invest more aggressively, as he initially worried; instead, he needs to invest less aggressively.
Yes, I’m oversimplifying the investment selection process. I strongly urge you to talk to an investment professional during the last 10 years of your career to ensure your portfolio isn’t subject to unnecessary risks. Between your current balance and your future deposits, they will be able to tell you exactly what rate of return you need to accomplish your retirement goal.
There are two major takeaways from the story of Stan and Tasha. First, the next time you see someone in their 20s, scream at them until they agree to start investing regularly (or suggest it nicely). And second, don’t panic when you’re 10 years out from retirement. Stan’s gut told him to get more aggressive, when in reality, being less aggressive was the solution.