compound interest

Money Grows (Just not on Trees)

© Can Stock Photo Inc. / tobiasott

If you put $10,000 into a savings vehicle that paid 2% annual interest, how long would it take you to double your money?

The intuitive answer would be 50 years: 50 x 2% equals 100% return. But due to the effects of compound interest, you’d actually get there in 36. You’re not just getting interest on the money you originally put in, you’re getting interest on the interest you’ve already earned.

Doubling your money in 36 years is not terribly impressive. But then, 2% is not a terribly impressive rate of return. At 4%, as you might expect, you can double in half the time: a mere 18 years. And in 36 years, you’ll have doubled twice, to quadruple your original money. In 54 years, it will be eight times what it originally was! That sounds like a long time, but if you started saving in your twenties you could reasonably expect to have 50+ years for your earliest savings to compound.

And that’s at a relatively conservative 4% annual return. As your rate of return increases, your compounded returns increase exponentially. At 5%, your money will increase tenfold in 50 years. At 6.5%, your money will increase twentyfold in the same time: a mere 1.5% increase in returns doubled your money over 50 years! It doesn’t take very many doublings to turn modest savings into a sizeable pile of money.

Of course, sometimes this is easier said than done. Returns are never guaranteed and pursuing higher returns generally means accepting more volatility and risk.

The math behind compound interest can be difficult to grasp, but there’s a simple guideline you can use to estimate long term returns known as the Rule of 72. If you take 72 divided by your annual rate of interest, the answer will be (roughly) the number of years it takes for your investment to double. If you divide 72 by 2, for example, you’ll get 36—exactly as stated up above.

If you would like to see how this works with real money, call or email us.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. investing involves risk including loss of principal.

Putting the Security Back in Social Security

© Can Stock Photo Inc. / CBoswell

There is a recurring concern that comes up when discussing retirement planning with clients. When we sit down with someone to break down various sources of retirement income, sometimes they will stop me and say “Mark, I don’t want to count on Social Security because I’m pretty sure it will be gone by the time I retire.”

It’s an understandable concern. We see headlines all the time calling for Social Security reforms (meaning cuts), throwing around scary words like “default” and “insolvent.” However, it is important to remember what these words really mean. If someone owes you $100.00, and they can only pay you back $99.97, they are technically insolvent. But you’re not really going to miss those three cents all that much.

The Social Security trust is short more than a couple of pennies, but the concept is the same: the program has merely enough funding to meet most of its obligations rather than all of them. You might hear estimates that the Social Security trust fund will “run out” within 20 years, but this does not mean the end of Social Security. Even without the support of the trust, the Social Security program is projected to have enough revenue to continue paying out approximately 75% of its obligations after the trust runs out (according to the latest annual report of the trustee board at ssa.gov.)

This is still a problem, obviously. No one wants to wake up in 20 years and hear their benefits have been cut by 25% because Social Security ran out of money. Thankfully, the fixes are not onerous. The math behind the Social Security trust, as with any pension fund, is based on the principle of compound interest—something that Albert Einstein is said to have called the greatest force in the universe. Staving off that future 25% drop can be accomplished by a smaller 13% decrease in benefits or increase in revenues today (representing a payroll tax of about 2%.)

These changes will undoubtedly cause some pain and there will be resistance to Social Security reforms. None of us knows what the future may bring, so it may be foolish to treat benefit projections as hard and fast numbers. But it seems clear to us that Social Security will likely survive in some form.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.