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I’m reminded of this anecdote as I read a steady stream of media reports that describe how a majority of working Americans are not saving (and investing) enough of their income to maintain their standard of living in retirement. Mere mortals are not wired like Warren Buffett, but unfortunately even many adult Americans do not seem to comprehend compound interest, which is what Albert Einstein called the “eighth wonder of the world.” The physicist added: “He who understands it [compound interest], earns it…he who doesn’t…pays it.” I’ll provide a vivid example of the importance of saving soon and saving often, but before that let me briefly summarize the lamentable findings of a few recent national savings studies.
The Employee Benefit Research Institute (EBRI) survey in 2012 concluded that 60% of workers 55 and older have less than $100,000 socked away for retirement (excluding home equity and defined benefit plans) and 59% of workers age 35-44 have never even bothered to calculate what they need to save for retirement. Boston College’s Center for Retirement Research, analyzing Federal Research consumer finances data from 2010, concluded that the outlook for retiring Baby Boomers and Generation Xers is far worse than for current retirees. The Center says that 53% of American workers 30 and over are on a savings path that implies a cut in standard of living in retirement (compared to 38% in 2001 and 30% in 1989), even if they work to age 65, which is two years later than the average American works. The Washington Post on January 15, 2013 reported that more than one-quarter of American workers with 401 (k) and other retirement savings accounts are raiding these accounts prior to retirement to pay for current expenses.
Now clearly, two stock market crashes in 13 years, a housing bust, a deep recession and stagnant wages for most workers have not helped matters. But for some reason Americans seem to have much more trouble saving for retirement than do Germans, Chinese, Japanese and citizens of many other countries.
A better understanding of compound interest would help. Workers need to start saving—and investing—earlier in their careers to let the elegant math of compounding work its magic. And instead of trying to time markets, workers should save and invest regularly, ideally monthly. I have written previously about how this dollar-cost averaging tactic with incoming cash flows from labor income rewards savers even during years of volatile stock markets (How Stocks Reward the Patient Saver).
Unfortunately, too many workers don’t seem to wake up to saving for retirement until they are in their 40s or 50s. This is too late for most people. For instance, the Center for Retirement Research estimates that the savings rates required for workers to achieve 80% of their preretirement income if they retire at 65 are as follows: 15% for those who begin saving at age 25; 24% for those who start at 35; and 41% for 45-year-olds.
Now it’s time to present an illustration of compounding and the importance of starting to save and invest money early in a working career. The table and graph below depict four savings scenarios during the 40 years stretching from January 1, 1973 to December 31, 2012. In each case, $1,000 is invested at the start of each month in a 60 stock/40 bond portfolio consisting of the S&P 500 Index and the Barclays Aggregate Bond Index, rebalanced quarterly. We used actual market returns during the 40 years.
Note in particular the difference between Case 1 and Case 4. In Case 1, the saver put away $1,000 monthly from January 1973 to December 1992, then stopped saving. In Case 4, the worked waited 20 years before starting to save $1,000 monthly for 20 years, from January 1993 to December 2012. In both cases, the workers invested $240,000 ($1,000 per month for 240 months), but in the first case, due to the compelling math of compound interest, the terminal value at the end of 40 years was $4.5 million, while in the second case the final value was only about 1/10 as much, $469,000.
Many American workers are failing to save enough to fund their retirements. One reason for this is that they start retirement planning and savings too late in their working lives. A better understanding of the power of compounding could help workers to start saving and investing earlier in their careers.
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