How can compound interest boost your retirement savings?
From paying off a HECS debt to buying a house, many of us are constantly weighed down by our financial obligations. Unfortunately, the ongoing money pressures we face now can often make it hard to devote any effort to saving for the future.
But saving for the future is something each and every one of us must do. It’s important to start saving as early as possible and put plans into place for the years to come. And thanks to the benefits of compound interest, you might not have to do as much of the financial heavy lifting as you think.
Compare savings accounts that use compound interest
In July 2015, Australia’s Productivity Commission released a research report entitled Superannuation Policy for Post-Retirement. The most fascinating figures revealed that the retirement incomes of Australians are usually 70% funded by net investment returns and only 30% funded by super contributions. On a first reading that sentence might sound incorrect, but this is truly the effect that compound interest can have on your retirement savings.
Compound interest means that you earn interest on the money you invest, and on your interest earnings. As long as the interest you earn is reinvested rather than withdrawn from the account, you continue to earn interest on your interest. The resulting snowball effect can see even the smallest of savings balances grow into something much more sizable over time.
How can compound interest benefit my super balance?
There’s a pretty good reason why Albert Einstein once referred to compound interest as the “eighth wonder of the world”. Compounding allows you to enjoy earnings on top of earnings on top of earnings, helping you to grow a larger retirement savings balance without having to lift a finger.
Because you are unable to access the funds in your super account until you retire, the earnings from your superannuation investments accumulate over time. Instead of being withdrawn, your investment earnings are instead reinvested by your super fund, allowing you to earn interest on top of the interest you’ve already earned.
As you’ll see in the examples further down the page, the effect of compound interest can mean that when you start saving is often more important than how much money you actually contribute to your savings. By investing early and earning interest on your interest over a long period of time, your retirement savings balance can grow exponentially.
Combine this with Australia’s Superannuation Guarantee rate, which is currently 9.5% of earnings but will rise to 12% within the next decade, and the impact of compound interest increases even further. From the time you start work as an employee, you will receive at least 9.5% of your salary paid into your superannuation account. Let’s say you enter the workforce at 18 years of age – by the time you retire, you will have been receiving regular contributions and earning compound interest on your super balance for almost 50 years.
Sue and Steve save for retirement
Steve will turn 65 at the end of 2016 and plans to retire. Although he’s been working full-time since the age of 16, Steve didn’t even begin to think about his super until the beginning of 1992, at age 40. Since that time, Steve has religiously ensured that 10% of his $75,000 income (including compulsory employer contributions) has been deposited in his super fund each year – $7,500 a year for 25 years. Assuming annual investment returns of 7% (after fees and tax) each year, Steve will have a balance of $474,368.
Meanwhile, Sue is exactly the same age as Steve and also plans to retire from part-time self-employment at the end of 2016. Although her salary is markedly less than Steve’s at $45,000, Sue has been contributing $2,500 to her super every year for 40 years. Assuming annual investment returns of 7% (after fees and tax) each year, Sue will have super savings of $499,088.
This is a perfect example of compound interest in action. Although Sue has actually contributed $87,500 less than Steve to her superannuation, she has almost $25,000 more than Steve to fund her retirement.
|Annual super contribution||$7,500||$2,500|
|Contributions started||1992 (at age 40)||1977 (at age 25)|
|Years contributions made||25||40|
|Super balance at retirement||$474,368||$499,088|
Australians and retirement
Retirement is meant to be a time to relax and live the life you want to, but the unfortunate reality is that many Australians run the very real risk of outliving their retirement savings. The Productivity Commission’s Superannuation Policy for Post-Retirement report revealed that:
- In 2011–12, 15% of people aged 45–54 had no super (page 6).
- Around 20% of Australians who reached the preservation age in 2011–12 had no superannuation, and by the age of 64 - just prior to the current Age Pension age — this rose to around 40%. By the time they reach 80 years of age, only 17% of Australians have any super remaining (page 7).
- The Age Pension is still an integral part of the income most Australians receive in retirement, with around 70% receiving a pension at some stage after turning 65.
These are alarming statistics and show the importance of starting to save for retirement as early as possible so that you can take advantage of the benefits of compound interest.
However, it’s also worth pointing out that Australia’s compulsory superannuation contribution system is maturing. The Superannuation Guarantee was introduced in 1992 to make it compulsory for employers to contribute to their employees’ superannuation. The contribution rate currently sits at 9.5% of an employee’s earnings but will rise to 12% by 2025.
This means that while 65-year-olds retiring in 2016 will only have been making super contributions for around half of their working lives, soon Australian retirees will have made contributions for most or all of their working lives. Hopefully this will lead to a marked reduction in the proportion of Australians who outlive their retirement savings.
The benefits of compound interest when saving outside super
Compound interest not only benefits your retirement inside super but also when you save money outside super. Opening a savings account that pays compound interest means that your money is working harder for you. Not only do you earn interest on the initial amount you deposit but also on the interest payments you receive. The net result of this is that your savings balance grows much more quickly.
On the flipside, an account which pays simple interest, such as a term deposit, does not have the same savings power. Simple interest means that interest is only paid at the end of a specified term, for example 12 months.
Let’s say you invest $15,000 in a term deposit for five years at an interest rate of 5% p.a., with interest paid yearly. By the end of five years, your balance will have grown to $18,750. But if you invest the same amount at the same interest rate in a savings account that calculates and adds interest monthly, your account balance would grow to $19,250 in the same period. That’s an extra $500 in interest that has been paid into your account.
And that’s just across five years. Spread out across the period of your working life, compound interest can provide a huge boost to the bank balance of any dedicated saver.
The benefits of starting early
The effects of compound interest also mean that it’s beneficial to start saving as early as possible. To explain this feature, let’s take a look at two 25-year-olds, Kirby and Craig.
Kirby is a committed saver and puts $100 into a savings account every week for 10 years. The account pays interest at 5% p.a., compounded monthly, and by the end of 10 years she has a balance of $67,289.
|Year 1||Year 2||Year 3||Year 4||Year 5||Year 6||Year 7||Year 8||Year 9||Year 10||Total|
|Total interest earned||$121||$514||$1,193||$2,173||$3,469||$5,098||$7,076||$9,421||$12,152||$15,289||$15,289|
Meanwhile, Craig decides to delay saving for the next five years while he travels the world. He then plans to start saving at an advanced rate and put away $200 every week for the remaining five years. This means he will invest the exact same amount of money as Kirby, and he will invest it in an account that pays interest at 5% p.a., compounded monthly. But by the end of the 10-year period, Craig only has a savings balance of $58,939. That’s a whopping $8,350 less than Kirby has saved, and it’s all thanks to the effects of compound interest.
|Year 1||Year 2||Year 3||Year 4||Year 5||Year 6||Year 7||Year 8||Year 9||Year 10||Total|
|Total interest earned||$0||$0||$0||$0||$0||$242||$1,028||$2,386||$4,346||$6,939||$6,939|
Compound interest really does have a significant effect on the amount you can save for your retirement. The earlier you start investing for the future, the better.