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By Michael Mooney, MBA, CFP, Financial Advisor
You may have heard that individuals that start saving early for retirement (or other investment goals) will be better off than late savers. This article will explain why that is the case, as well as the importance of compounding when it comes to your investment accounts.
Two employees make the exact same salary of $50,000 per year. In both cases, they also contribute to their retirement account for exactly 20 years, and both plan on retiring at Age 65. They both even invest in the same investments making the same average annual return. Employee A contributes $2,500 per year in each of those 20 years, while Employee B contributes $5,000 per year in each of their 20 years. Would you guess that Employee A has more saved at retirement than Employee B? Probably not, but that is the case! In fact in this example, Employee A makes half of the contributions that Employee B makes, but ends up with more than double the amount saved! How is that even possible? See below example for explanation.
Context (and more importantly COMPOUNDING) is important!
Employee A:
$50,000 Salary
Starts Saving at Age 22
5% Annual Savings Rate ($2,500/Year)
Stops Saving at Age 42 (after 20 years of savings).
Average Annual Market Returns of 7%
Employee A has $519,860 saved when they retire at Age 65.
Employee B:
$50,000 Salary
Starts Saving at Age 45
10% Annual Savings Rate ($5,000/Year)
Stops Saving at Age 65 (after 20 years of savings).
Average Annual Market Returns of 7%
Employee A has $204,977 saved when they retire at Age 65.
This information is hypothetical. It is not intended to represent any specific return, yield or investment. It is provided for illustrative purposes only and does not constitute a recommendation to invest in any particular asset class or strategy and is not a promise of future performance or an estimate of actual returns a client portfolio may achieve. Hypothetical and past performance do not guarantee future results.
This example shows the importance of the time value of money. Employee A starts saving earlier in their career, and has more years of compounding. While they make less overall contributions, they should end up with more money in the long run. The notion that “I’ll just wait to save, and save more down the line” is much more difficult than it seems.
While we would applaud Employee A for starting their savings early on in their career, this is just an example. As Investment Planners and Advisors, we would recommend to them that they should continue to save throughout their career, rather than stopping after 20 years.
Saving EARLY and OFTEN is a great strategy to give you a better chance of reaching your investment goals, including retirement spending. Saving that extra 1% out of your paycheck now, rather than buying that fancy new car, could make a difference of thousands of dollars down the line due to compounding.
Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.