Compounding interest is a powerful tool for retirement saving

Jeff Witz, CFP

Many physicians have ambitious financial goals.If you hope to reach those goals, comprehensive financial planning is critically important. Many different areas will need to be shored up: emergency fund, disability insurance, life insurance (if you are planning for yourself and a spouse), tax planning, an investment strategy, etc. Some of these items are necessary to ensure that if something negative happens during your career, you and/or your spouse may still be able to achieve your goals. Other items are designed to help grow and maintain your wealth. However, the 2 financial concepts that may have the biggest impact on your ability to achieve your goals are early saving and investing to take advantage of compounding interest and growth.

Compounding interest and growth are incredibly powerful financial concepts. Compounding interest is interest on interest or growth on growth that helps your investments grow at a faster rate. How does it work? Let’s say you make an investment, and that investment is supposed to pay you interest or a dividend. Instead of taking the interest or dividend payment as cash and sticking it in your pocket, you reinvest it in the same investment. The next time that investment pays out interest or a dividend, it does so not only on the original principal investment but also on the reinvested amount.

Think of it as a snowball you’ve started rolling downhill. As the snowball continues to move downhill, it grows in size and momentum. By the time you reach one of your financial goals such as retirement, this investment-fueled snowball has hopefully grown big enough and has such tremendous momentum that it’s churning out the income you need on the first day of retirement and the last. The longer you take advantage of compounding interest before withdrawing the funds, the greater the impact compounding interest can have in growing your investment accounts. That’s why starting to save and invest early is critically important.

Let’s look at an example of the power that saving, investing early, and taking advantage of compounding growth can have. Rachel and Ross are both aged 27 years and thinking about their futures. Rachel is a saver and starts saving $6500 in her individual retirement account (IRA) every single year. However, after 9 years, at age 36, Rachel decides she is done saving and wants to start spending her money instead, so she stops making IRA contributions. Ross, on the other hand, has a lot of student loan debt and decides to pay that off before saving for retirement. Ross doesn’t start saving for his retirement until age 36, the same age at which Rachel stopped contributing to her IRA. Ross contributes $6500 to his IRA for the next 29 years until he reaches age 65. As a quick recap, Rachel contributed $58,500 to her IRA over that 9-year period and Ross contributed more than 3 times as much: $188,500 over a 29-year period.

If we assume a 7.2% annual rate of return on the investments in their IRAs, at age 65, Rachel will have accumulated approximately $589,600 in her IRA and Ross will have accumulated approximately $587,700. Rachel contributed less than one-third of what Ross did but ended up with more money at retirement. That is the beauty and power of compounding interest and growth afforded to those who can start saving and investing early. The 9 years of extra rotations that Rachel acquired for her retirement snowball had a huge impact on the amount of assets she had at retirement. Had she continued saving until retirement, you can imagine that her assets would have been significantly higher than Ross’.

The presented performance represents hypothetical projections during the measurement period. As such, these results have limitations, including but not limited to the following:

Projected performance may not reflect the impact that material economic conditions and market factors would have had on the adviser’s decision-making or on individual clients or the impact of the timing of actual client cash flows into or out of an actual portfolio.

Results do not reflect actual trading by specific clients but are assumed based on the rule of 72, which provides an estimate for how long it takes an investor to double the value of an investment using compounding growth at a given rate of return. Dividing 72 by the assumed rate of return will provide the estimate of the amount of time when the value can double (72÷7.2=10 years)1

Projected performance does not reflect brokerage commissions, custodian fees, taxes, or any other expenses a client would have paid, and as such, actual investment returns would be lower.

Projected performance is no guarantee of future results.

Investing involves risk, including the risk of losing principal.

Investments with potential for higher returns carry greater risk of loss.

All investors must consider their specific risk tolerances before any financial strategies are chosen for investment purposes.

Saving and investing early gives you a steeper hill to roll your snowball down to grow it even bigger and enables you to compensate for changes in investment markets or your financial goals as you progress through your career and life. Our experience has been that many physicians struggle to save early in their careers. Student loans, down payments for houses, and a general increase in standard of living consume all their income even though they are making 5 to 10 times as much as they were during their residency or fellowship. It is critically important to find a balance between saving and spending. Create a budget to keep your spending reasonable and free up funds to start saving and investing as soon as possible. Saving and investing a modest amount regularly and early in your life can have a huge impact on your ability to reach your financial goals.

Reference

1. EE204: Business Management for Electrical Engineers and Computer Scientists: The Rule of 72. Stanford University. Accessed July 24, 2023. https://web.stanford.edu/class/ee204/TheRuleof72.html

MEDIQUS Asset Advisors, Inc. does not provide tax, legal or accounting advice. The information contained in this report is for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction or regarding any questions you may have with respect to this communication.

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