How Compounding Benefits Your Retirement Savings

Supersizing the savings you have invested for retirement likely sounds too good to be true. You may have heard that some people managed to amass a $1 million-plus IRA balance and wondered how they did it. While I don’t know about everybody's strategy, let me turn your attention to the wonders of compounding and time.

Popular Approaches to Retirement Investing

Many people think that the focus of investing is on picking investments. In an attempt to boost investment return, another approach is through systematic investing. If the stocks or funds you invest in pay dividends, you get dividends on two shares instead of one share in a 401(k) or 403(b) employer-sponsored retirement program every time you contribute funds. Here you continue to put the same amount in on a consistent basis without taking your money out. The thinking behind this investment strategy is that rather than try to time the market to get in and out, you let the market up and downs work for you. When the market goes down you are buying for less. A stock that was $50 might now be $25. You can buy two shares rather than one. (For more, see: The Awesome Power of Compounding.)

Using Time and Systematic Retirement Investing

The other part of the strategy has to do with time. Simplistically, you are allowing growth on your investments to compound over time.

Some people who focus on picking investments and market timing have not considered what small investment returns compounding over time might provide. The following returns do not represent a specific investment strategy. They simply illustrate the mathematical concept. The first table illustrates an assumed annual rate of return of 5% and a $5,000 annual contribution.

Years

5

10

20

40

50

Payment

 $5,000

 $5,000

 $5,000

 $5,000

 $5,000

Interest

5%

5%

5%

5%

5%

Periods

5

10

20

40

50

Total Investment

 $25,000

 $50,000

 $100,000

 $200,000

 $250,000

Total Return

$29,009.56

$66,033.94

$173,596.26

$634,198.81

$1,099,076.98

Return on Investment

16%

32%

74%

217%

340%

The difference between a five year and 10-year return is double. Over the following 10 years the growth is more than double. Over the next 20 years the return is almost triple that of the 10-year return. This is where the power of compounding begins to be most noticeable. If you are age 21 and don’t touch the money until you’re 71, you have put in $250,000 and have gained roughly $1.1 million – a return of 340%. (For more, see: 4 Keys to a Satisfying Retirement.)

Now let’s look at what would happen if you were to achieve a 7% rate of return.

Years

5

10

20

40

50

Payment

 $5,000

 $5,000

 $5,000

 $5,000

$5,000

Interest

7%

7%

7%

7%

7%

Periods

5

10

20

40

50

Total Investment

 $25,000

 $50,000

 $100,000

 $200,000

 $250,000

Total Return

$30,766.45

$73,918.00

$219,325.88

$1,068,047.85

$2,174,929.77

Return on Investment

23%

48%

119%

434%

770%

After 40 years your compounding investment returns would be over 400%. Ten short years later the return would be 770%. Contrast that with the math that only garnered a 48% return. That is the power of the compounding. Please note that these are hypothetical examples that are not representative of any real situation. The hypothetical rate of return used does not reflect any particular investment. Your results will vary.

What's next?

Are you ready to start benefiting from a retirement investing strategy based on compounding? What goal would you like to target? You can ask your Certified Financial Planner™ professional, Chartered Retirement Planning Counselor or other retirement planning designation holder for help. (For more, see: What to Do to Prepare for Retirement.)

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. No strategy assures success or guarantees against loss. Investing in securities is subject to risk and may involve loss of principal.