Time is the greatest advantage young adults have in saving for retirement. Individuals who start saving at an early age can save fewer dollars, save fewer years, earn less return, and still retire with more money than individuals who delay saving until an older age. This phenomenon is known as the power of compound interest. Compound interest occurs when earned interest is added to the principal investment, and future interest is earned on both the principal investment and interest previously earned. I have generated a few calculations to demonstrate the power of compound interest. I believe the results clearly show that when saving for retirement, starting earlier is better.
Example One:
Person A saves $5,000 on his 35th through 64th birthdays (30 years) and earns 8% annually after taxes. On his 65th birthday, Person A will have an account balance of $611,729.
Person B saves $5,000 on her 25th through 64th birthdays (40 years) and earns 8% annually after taxes. On her 65th birthday, Person B will have an account balance of $1,398,905.
Person B's balance is $787,176 greater because she started saving ten years earlier than Person A.
Example Two:
Person A saves $5,000 on his 35th through 64th birthdays (30 years) and earns 8% annually after taxes. On his 65th birthday, Person A will have an account balance of $611,729.
Person B saves $3,000 on her 25th through 64th birthdays (40 years) and earns 8% annually after taxes. On her 65th birthday, Person B will have an account balance of $839,343.
Person B saved $2,000 less per year than Person A, but Person B's balance is still $227,614 greater because she started saving ten years earlier than Person A.
Example Three:
Person A saves $5,000 on his 35th through 64th birthdays (30 years) and earns 8% annually after taxes. On his 65th birthday, Person A will have an account balance of $611,729.
Person B saves $5,000 on her 25th through 64th birthdays (40 years) and earns 6% annually after taxes. On her 65th birthday, Person B will have an account balance of $820,238.
Person B earned 2% less return than Person A, but Person B's balance is still $208,509 greater because she started saving ten years earlier than Person A.
Example Four:
Person A saves $5,000 on his 35th through 64th birthdays (30 years) and earns 8% annually after taxes. On his 65th birthday, Person A will have an account balance of $611,729.
Person B saves $5,000 on her 25th through 34th birthdays (10 years) and earns 8% annually after taxes. On her 65th birthday, Person B will have an account balance of $787,176.
Person B saved twenty fewer years than Person A, but Person B's balance is still $175,447 greater because she started saving ten years earlier than Person A.
As these examples demonstrate, the compound interest generated by starting to save ten years earlier will produce a greater account balance at retirement. Starting to save ten years earlier can result in a greater account balance even if the individual saves fewer dollars, saves fewer years, or earns less return. Compound interest and time can help heal unfortunate investment experiences. Time is a friend to young people saving for retirement. Start saving early, and time will treat you well.
