To hear some financial planners say, compound interest is a magic carpet: save early and often, and in 40 years of hard work your pennies will turn into millions.
That’s how it was explained to Chris Browning, assistant professor in the personal financial planning department at Texas Tech University in Lubbock. When he was impressionable at 25, he was dazzled by the simple calculations rolled out by an enthusiastic planner.
Then reality set in. “I hate how it’s sold to people like it’s a lottery winning strategy,” Browning says. Capitalization, he says, “isn’t as amazing as people make it out to be.”
That’s because the simple compound interest equation is simultaneously eroded by five factors: fees, inflation, taxes, market performance, and other ways you might spend your money.
That’s great news if you’ve just added to your retirement savings. You haven’t lost as much as you might have feared. And if you accelerate your savings in the 20 to 25 years before you retire, you can still enjoy a lot of compounding power, experts say, even after real-world factors.
The tax error in capitalization. Financial planners love to emphasize the power of compounding because it sounds like magic. The basic idea is that as you save, you get returns on investment not only on the amount you save, but also on the returns on investment. As your savings accumulate, you get more returns on the ever-growing total.
As the accompanying table illustrates, simple capitalization accelerates simple savings. If you start at age 25, save $250 a month, and earn 7.5% a year, you’ll gross a return of nearly $900,000 by age 65.
The graph illustrates the effect of fees and inflation on compound interest. The blue line shows how much premiums increase with simple funding, based on a 25-year-old who saves $250 a month for 40 years and earns 7.5%. The red line takes into account an investment fee of 0.5%. The green line shows the combined effect of the 0.5% fee plus an annual inflation rate of 3%. The purple line shows the total amount paid into the account, with no interest earned.(Texas University of Technology)
Factor in the lowest investment fees of 0.5% per year and you’ll see more than $100,000 evaporate from the pink projection, Browning says. (And if you’re paying a planner, include those fees as well.)
Now factor in both the 0.5% fee and a 3% annual inflation rate, and the value of your treasure is cut in half, Browning says.
It’s worse: you’ll have to pay taxes somewhere along the line.
The markets, Browning says, might not cooperate with your plan and deliver a steady 7.5% annual return. This will affect the potency of the capitalization.
Finally, what if your relentlessness in fueling the compounding engine means you can’t pay off debt or do things you love?
“The typical person can probably save a million dollars in their lifetime, but they’ll be unhappy doing it,” says Mark Calabria, director of financial regulatory studies at the Cato Institute.
Think experiences, education, and just plain fun. Are you willing to give them up today so you can have a bunch of cash, hopefully in a few decades? Calabria says a healthy mix of living today and living tomorrow is the perspective that motivates people to reach their savings goals. Arithmetic exercises, like the classic example of compound interest, rarely inspire, he says.
How to make composition work for you. Capitalization has its place, advisers say. First, it’s good to understand the concept, as it helps you make simple comparisons.
One of those comparisons should be how much you lose by paying fees, says Catherine Hawley, a financial adviser based in Monterey, Calif. “Fees can run into the thousands every year, and that’s money you never see,” says Hawley, who recommends clients check out FeeX.com, which analyzes the real impact of different tiers. and combinations of investment costs.
Hawley also says that using one-dimensional compounding as a benchmark can help you understand which factors you can control when it comes to saving and investing and which factors are beyond your control. The math, taxes, and market are beyond your control, but you can control the fees, your savings rate, and the lifestyle trade-offs you make today to save for tomorrow.
If you start accelerating your retirement savings in midlife, you’re probably in your peak earning years, which means you can save more and get to the finish line faster, Browning says.
Easy adjustments to your savings schedule can also increase the power of compounding. Browning says you can save thousands of extra dollars over your working life by simply putting your monthly contribution into your account on the first of each month, not the last day.
And, he says, funding offers an additional virtue: If you’re interviewing financial advisors, you can sketch out their approach to customer service by asking how they sync funding calculations with your overall life and financial goals. Those who look at all the moving parts – and don’t just hammer away at what you don’t have because you didn’t get the most out of capitalization earlier – are likely to take the holistic approach that you will take you where you want to go.