Compounding Is Important in the Later Years Too

Yesterday I answered a press request asking about the best time to start saving for retirement. The standard answer is as early as possible. This comes from the idea that having more years to compound your returns will lead to a bigger account. I argue it’s the years at the end that are more important than the early years.

The Power of Compounding

First let's review the power of compounding. When you invest money and earn a return your account is worth more at the end of the year. In the second year, you earn a return on a larger amount than the first year because your beginning balance in year two is the original year one principal plus the year one return earned. Each successive year will see larger gains as return is earned on a larger starting amount. The account will continue to grow even without new additions.

The common thinking is that if we start early, then we will be earning a larger and larger amount every year. While this is indeed true, we must start with a significant amount to make the compounding worthwhile. The annual compounded return on $100 won’t get us much closer to retirement. 

When young people finish school and start working, around age 22, they usually are not making a significant salary. This leaves them little extra money available for saving. If someone starts with saving $100 per month or $1200 per year, and earns 7%, then how much will they have after five years? My financial calculator tells me it’s $6,900. (For related reading, see: How to Start Saving for Retirement.)

This person did the “right thing” and started early in their retirement savings. While saving $6,900 is better than saving less than $6,900, I argue that saving this much by age 27 is not crucial to retirement. A large contribution in year six can easily make up for the first five years. Say for example this person got a new job or a raise. The money they earn from their higher-paying job can easily make up for the previous five years of saving and investing.

It’s Not Just How Early You Start, but How Much and How Long You Save

Now we look at return at the beginning of the 30-year time frame versus at the end. When this example person is 28 years old and in year six of compounding, a 7% return on the $6900 they struggled to accumulate over five years will return $483. At the end of the compounding years however, when the account value is say $1,000,000, then he or she will make a $70,000 return in one year. Just one additional year at the end brings another $70,000 versus $483 at the beginning. (For related reading, see: 6 Retirement Savings Tips for 45- to 54-Year-Olds.)

As this person progresses in their career, they will receive pay raises and move up the corporate ladder. Using these pay raises wisely will have a more significant impact on their retirement than saving as early as possible. Staying invested at 7% for three additional years at the end of their career will turn a $1,000,000 portfolio into $1,225,043, 22% more savings for retirement. See the importance of the later years?