Compound Interest: The Snowball Effect on Your Savings
Saving enough for retirement can seem daunting, but compound interest can lend a helping hand.
Have you thought about retirement lately? Regardless of how old (or young) you are, saving for retirement should be on your mind. And, unfortunately, if thinking about it doesn’t scare you, you are probably underestimating how much you are going to need to put away to have the sort of retirement you are envisioning.
According to the Bureau of Labor Statistics, the average annual salary for a pharmacist was $116,670 in 2012. The top 10% in terms of salary earned $145,910 on average and the lowest-paid 10% earned $89,280 on average. Meanwhile, the median income in the United States was just $51,017 in 2013. Even considering the burden of student loans, those numbers might lead a pharmacist to think he or she will have no trouble saving up for retirement.
Even highly compensated workers are struggling to save for retirement, mostly because they need to save so much if they want to maintain their lifestyles.
According to TIAA-CREF, retirees will need at least 70% of pre-retirement income to maintain their standard of living. That means the average pharmacist will need to replace at least $81,648 of income per year during retirement. Assuming this average pharmacist retires at age 67 and lives to 90, he or she will need roughly $1.9 million in all. And if our hypothetical pharmacist lives until 95, then his or her nest egg will need to be $2.3 million. A pharmacist who starts saving at age 30 will have 37 years to accumulate that wealth, but it still comes out to saving $62,162 a year—more than half his or her pre-tax salary.
Now that you’ve seen the numbers, it makes sense that you need to start saving as soon as possible. Not only does starting early mean you’ll have less to catch up on later, but a lovely little thing called “compound interest” does some of the work for you.
Compounding, which Albert Einstein called the eighth wonder of the world, is a simple strategy in which interest earned by an investment is reinvested, producing even more interest to be reinvested year after year. Tom Dyson from Investment U likens compounding to a snowball rolling downhill, getting larger and larger. Although the buildup starts slow, the snowball quickly gains more speed, which lets it pick up more snow, which in turn lets it pick up even more speed.
With compounding, even if you put money into an investment or an account and leave it completely untouched, it will earn more and more over time. For example, let’s say a pharmacist puts $2000 into an account earning 6% annual interest. Every year for the next 10 years he or she adds another $2400, but then stops contributing and simply lets the money grow, untouched, for another 30 years. By the end, the $26,000 that was put into the account will turn into $202,260.49. Without compounding, the account would have earned a bit over $50,000 in interest; with compounding, it ended up with more than $120,000 extra.
Now, if he or she decided to deposit money into the account at the same rate for the entire 40 years, then the end amount would be $392,000. By putting away another $72,000, our smart pharmacist will be able to pull an extra $189,740 out of the account.
Don’t believe me? Play around with the compound interest calculator from Investor.gov. You can see how much of a difference an additional $1000 a year makes. Or what happens when you leave the money in an additional 5 or 10 years.
Saving $2 million for retirement doesn’t seem so daunting when you consider the effect of compound interest on your savings, plus what you put into a 401(k), IRA, or other retirement savings account.
Have a question about how to handle your own financial challenges? Send it to us at firstname.lastname@example.org.