It doesn’t matter if you’re 25 years old or 55 years old, or if you’re living above your means or below your means. It also doesn’t matter if you’ve been accumulating wealth for years or living paycheck to paycheck. The next five years will be the most important five-year stretch you’ll get in terms of increasing your lifestyle in retirement or limiting it. How can one make such a blanket statement regarding retirement, especially given the fact that I have no idea who you are or what your age is? It’s quite simple actually, something called compound interest.
Compound interest is the ability to earn money on the money you’ve invested, and then over time earning interest on that interest and so on. Over time your money begins to snowball and eventually you’re earning more on just the interest than what you’re contributing to the account. Consider two people, person A who is 25 years old, and person B who is 40 years old. Neither have any retirement savings, but both are ready to start. Both people would like to retire at age 60. Person A is able to save and invest $15,000 a year for only five years, and then invests the balance at age 30. By age 60, person A will have an amount of roughly $885,000. Person B begins saving $15,000 as well, however, they continue saving $15,000 a year until age 60. Their balance upon retirement? You’d think they would have amassed a much larger amount, but the value is only about $686,000, or nearly $200,000 less than person A. Even though person B would have saved much more ($300,000 in total compared to person A’s $75,000) the magic of compounding is on person A’s side due to a much longer time frame.
The above example assumes an 8% annual return. It’s visible that Person B is able to make some ground up initially once they start, but then the true power of compound interest kicks in for Person A and they’re basically able to make as much as Person B, even though they aren’t doing a thing.
Feeling discouraged because you didn’t get a jump on saving at a much younger age? Don’t be. I also didn’t start as early as I would have liked, however, I am now doing everything I can knowing how important compound interest is. It is often difficult to think about retirement in your 20’s, especially knowing that it may be as many as 45 years away. People in their twenties, on average, also earn much less than people in their forties. One thing to remember though is that every little bit helps. Consider someone who is 20 years old and contributes $100 a month into an investment account until age 60. They’d end up with roughly $350,000 (assuming an 8% return). If they delay their starting point until age 25 and then contribute until age 60 they will end up with about $230,000, a decrease of 35% even though they delayed their starting point by only five years.
The examples to show the importance of beginning today are endless, but one thing should be clear. The sooner you make a concerted effort to think about the future that you want the better off you will be. You can’t change the past but you can control what you’re doing today. Take a look at the chart below to see how the value of a $1 investment today, at various rates of return, can have a huge impact come retirement. Locate how many years away from retirement you are along the x-axis and then see how much $1 invested today would be worth for you at retirement. After you see the value of $1 at your current age move five years to the right. This is now the value of $1 at retirement if you delay five years. The impact should be very apparent. Don’t be too concerned about comparing the different rates of return. The chart is meant to show you that the earlier you’re able to start the better off you will be. You will see that the longer you have until retirement the more work your money can do for you.
What changes can you make today to help your future self? For starters, track your spending and see where the money is actually going. People generally have a good handle on their large expenses, but it’s the small ones that add up and really eat into savings. After you’ve done this try to make small changes over the next few months and invest the savings. Aren’t quite ready to invest? That’s okay. Focus on paying down your debts at least to see increased savings down the road. Paying down debt is just as important, if not more important than trying to scrounge up savings to invest. The important thing is to try to be in a better position a year from now than you are today, and then to build on that progression.