Tap into the magic of compound interest and save millions
The snowball effect of ‘growth-on-growth' cannot be underestimated
People who have been in the adult game for quite some time always repeat the mantra “save, save, save” when speaking to someone in their 20s or 30s. And rightly so.
However, when they stare at you with a blank look in their eyes, a little lesson in compound interest will go a long way to igniting the missing spark. If you are starting out in life, this article could just be what you need. If you are a little further down the road and know someone who has just started working, share this lesson with them.
Retirement is a long way away when you are in your 20s, but learning about compound interest at a young age will make saving towards retirement not only easier, but far more effective.
Let’s say you don’t start now, but when you reach 45 or even 55, you wake up to the fact that you need to start building your nest egg. You sit down with a financial adviser and work out what you will need in retirement — to illustrate the point, let’s assume you need to save a total of R5m. Let’s assume you have enough money left over each month to really “pump up” your retirement savings and you reach your goal.
That would obviously be great, but for most people this is not the case. It’s also a lot more expensive.
However, had you started at 25 — or even at 35 — a little bit of compound magic would have changed the whole scenario. The amount you would have had to put away to reach that R5m would be far less. In fact, most of your R5m would have been earned through investment gains.
To understand this better, Ultima has drawn up the table below. The blue section is how much of your own money you would have paid in contributions towards your retirement plan. The orange part is how much of the total R5m was reached as a result of investment gains, or growth.
Hendri de Klerk, a financial planner from Ultima explains compound interest like this: “Compound interest is best described as growth-on-growth, much like the snowball effect. A snowball increasing the surface with every roll and the longer it rolls the exponentially larger it gets.
Compound interest is best described as growth-on-growth, much like the snowball effect. A snowball increasing the surface with every roll and the longer it rolls the exponentially larger it getsHendri de Klerk, Ultima Financial Planners
“When it comes to a long-term savings plan, such as your retirement savings plan, you want to maximise on investment gains. Investment gains are essentially the compound growth part of your investment.
“If you start later in life, and should you be able to fulfill your objectives, then it will cost more contribution from your own side and less investment gains, as provided by the growth of a well-balanced and actively managed portfolio.”
Most employees in SA do not work for a company that offers a compulsory pension fund. This means that to take advantage of compound interest in your retirement savings, you need to make some very responsible, but hard decisions. You need to set it up on your own — and sooner than later.
This may seem easier said than done. We all know that the cost of living is sky high, and none of us earn as much as we want to. With this in mind, De Klerk offers 10 tips for young people starting out in the world of work.
Ten financial priorities for people in their 20s
1) Get a medical aid — medicine is expensive when the unexpected happens and having the option to use private medical care is very important.
2) Save for retirement — we recommend that people save at least 10% of their remuneration, but 15% would secure a comfortable retirement. A more aggressive approach is advised.
3) Secure disability insurance in the form of an income protector that will pay you a monthly income in case you can’t work any more.
4) Pay off your study loan — many students today have a study loan to repay and, depending on the interest rate, the level of priority might change.
5) Life insurance — especially for young, married career starters. Life insurance becomes more of a priority as you have a family that is dependent on your income.
6) Short-term cover for assets
7) Emergency fund — we always advise clients to have an emergency fund with at least three months’ salary value. An access bond or a call account linked to your bank account are easy ways to set up a solution.
8) Save for a deposit on your own property (future primary residence).
9) Ensure you have a valid will in place.
10) Budget-planning/spend-tracking — it is important to be fully aware of your expenses which can be tracked using a spend-tracking app linked to your bank account.