Compounding A Lifetime Savings Plan

Compounding interest on savings is a powerful engine that can produce surprising results over time.  This post is about the idea of compounding and is an important one for future posts.

Compounding trends begin slow and can afford a bit of deception.  Say you have $10,000 to save one year and assume you can put that money to work in an investment generating 7% interest.  Your earnings from letting that money go to work for you is $700 that year.  Or you could buy a modest set of new furniture for the living room with the $10k. 

…But since you”re reading the blog here you are more inclined to stand (no furniture) while your investment sits (in an investment).  We”re using $10k since that was the IRA contribution rate for years (now it”s indexed a bit higher) as well as the traditional amount that consumers see in investment planning and advertisements “your $10,000 invested with us three years ago would be worth this big pile of cash! Better call us soon!”…

A Warren Buffet quote that was told when his wife wanted to refurnish their modest home was “Do you know how much $20,000 will compound in twenty years?!”  Now Warren was getting a much greater interest rate return than we”re playing with here.

Were we started was the saving strategies that two people can each take:  Abe puts $10k away every year from his 25th birthday until his 35th birthday and then stops adding to his investment account.  Meanwhile his brother Billy waits until he”s 35 – spending all those earlier $10k”s on fast cars and trinkets – and then tries to catch up by saving $10k from his 35th birthday until his 65th.  Abe put in $100,000 while Billy put in a total of $310,000 over those 31 years.  They both have over a million dollars to retire on but Abe saved a third less and ends up with 20% more money than Billy.

This same analysis can be extended to situations where a person is considering career paths.  Assuming they can be frugal no matter what occupation they choose, and save in chunks of $10k, they would each end up with the following savings trend:

Descriptions of the types of trends shown:

Frugal= saves $10k from 25yrs to 35yrs old (Abe)
YoungFlashy= save $10k from 35yrs to 65yrs old (Billy)

High School= saves $10k from 18yrs through 35yrs old
College (4yr)= spends $10k for each of four years of school, then saves from first job at 22yrs through 65yrs old.
Masters Degree (6yrs)= spends $10k for first 6 years, then saves $10k until 65yrs old
Phd Degree (8yrs)= spends $10k for 8 years and saves $10k until 65yrs old
Physician Specialist training (10yrs) = spends $10k for 10 years and saves $10k until 65yrs old

Assumptions: savings or payments are in chunks of $10,000 (or “$10k”), interest rate is 7%, amounts are compared at 65yrs of age, and occupational wage rates are removed from the equation – just a flat savings contribution of $10k is assumed (this is due to budgeting patterns… a doctor may live in a fancier house with more expensive new cars with high insurance costs and yet still only have the same $10k free cash to invest as someone else living in a low cost shack, driving a used car with low insurance, while getting paid much less – maybe working fewer hours too).  The extra time “in school” (4yrs to 10yrs) are calculated at negative $10k payments each year (school costs are often much higher – we”re just assuming the $10k that would have been put into savings with another choice is now being dumped into funding text books and “beer”).

Results for how much each savings strategy returns by age 65, shown on the graph above:
Frugal =          $1.2M  (input $100k, from 25yrs to 35yrs)
YoungFlashy=  $1M     (input $310k, from 35yrs to 65yrs)
High School=   $2.6M  (input $100k, from 18yrs to 25yrs)
College(4yr)=  $1.8M  (input $480k, from 18yrs to 65yrs, first 4yrs negative output)
Masters(6yr)=  $1M     (input $480k, from 18yrs to 65yrs, 6yrs neg)
Phd(8yr)=        $0.5M  (input $480k, from 18yrs to 65yrs, 8yrs neg)
Physician Specialist training (10yrs)= -$81,000  (input $480k, from 18yrs to 65yrs, 10yrs neg)

The Physician Specialist is the surprising one.  Due to the long period of paying out money (that compounds as a lost opportunity) and the delay in making money to contribute to a savings plan; they are actually in a negative savings position.

This also shows how you may have a “millionaire” living next door to you and you don”t realize it.  They could be regular people who never went to college for fancy degrees but had been fortunate to find a good job early on and were very good at saving, Like Abe.  Many people like Billy get caught in buying a bunch of furniture for their first apartment or new cars or credit card bills for vanity, travel or rewards in those starter years and don”t save anything until they get to 35 or so and realize they might want a retirement.

It”s easy to see how compounding can be deceptive – most people do not think those early years are that important – but they are critical to consider.  How can you store savings away while going to college?  Can you pick a college that is less expensive and won”t set you up for huge student loans?  There are also questions that can be asked, like a high school graduate may only get jobs paying X while the college grad can get jobs paying X+Y and potentially save “$20k” per year vs “$10k” – but they have to be serious about it.  Or if you can get 10% interest rate by focusing on investing in the stock market vs 3% in a regular bank savings rate.  Leave us some comments here and let us know what posts you might want us to focus on in the coming weeks. 

So Compounding interest can be a powerful engine in advancing your savings but it takes time and effort and really thinking about it when you start out.  You can play with the savings amounts and interest rates and so on but it”s easy to see that it”s tough to catch up.  Warren Buffet was right in being serious about spending money on furniture he didn”t think he needed.

We have been a bit curious if Billy or Abe ended up with the “hotter” wife, better job, or more balanced kids based on their spending patterns of apparent wealth (bigger house, newer car, trendy clothes) – us know your thoughts.

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