Compound Interest the Key to Retirement Planning

With looming threats of Social Security going belly up in the not too distant future, it is even more important for young people to have a good retirement plan. Congress, hoping to keep Social Security solvent a little further out in the future is contemplating a major overhaul of the system that has been with us since the days of President Franklin Delano Roosevelt. Already the age at which you can get full Social security benefits has moved up. It may hit 70 before too long. Employees and employers may have to pay more in to the system (taxes on higher earned income) as the government wrestles with the massive deficits of this very important safety net for the elderly and disabled. Preparing for the worst case scenario - no Social Security when you retire 30 or 40 years from today, is the prudent thing to do.

Don't Put Off What You Can Do Today for Tomorrow

Many twenty something's are too busy having fun and living their lives to even think about retirement planning. They're young and carefree. They want to enjoy the best years of their lives. Who needs to worry about money? That's the attitude many parents must fight when they warn their grown children to start retirement planning. Every financial advisor will tell you that the earlier you begin your retirement plan, the better the chance there is that your money will grow to a sufficient amount when it does come time to retire. The concept is called the power of compound interest. The more time an investment has to compound, the greater the potential return.

Setting Up a Plan

Most people are exposed to retirement planning through their job. The Human Resources manager will explain the retirement plan that the company offers. If you choose to join, a set amount of money will be taken out of your paycheck and invested in your retirement account. You can also have a secondary plan for retirement. You can invest in an individual retirement account (IRA) that you personally control. Whether you have a 401K plan at work or have an IRA in a personal account is not important. What matters is how much your money grows over time.

Time is of the Essence

The longer period of time you can leave an investment alone, the more likely it is to appreciate. That is a simple function of time on interest rates and the average rate of return. Not considering anything other than time, $100.00 today (present value) will be worth more in 10 years (future value). How much more depends on the average interest rate you earn over those 10 years. If you can earn an average of 15% each year for the 10 year period (that's 15% x 10 years), you might think you'd get 150% or $150.00 for a total of $250.00. You'd be wrong, because you did not take in to account the power of compound interest.

Compound interest in its simplest terms is calculated each time period (usually daily) and then theoretically added to the original total investment. In the above example, assume interest is calculated once per year. After one year, your investment will have grown by 15% or $15.00, giving you a total of $115.00. The second year, you would receive 15% of $115.00 for a total of $17.25 which is then added to make a new total of $132.25. The process continues throughout the life of the investment. By the end of 10 years, your investment will have doubled and redoubled making the original $100.00 now worth a bit over $400.00. You can see the power of time on compound interest.

Power of 72

The Power of 72 is a basic math concept that says an investment will double in the time period you get by dividing the average rate of return in to 72. In our above example, 15 goes into 70 between 4 and 5 times. Therefore, your money will double in just under 5 years and then double again close to 10 years (broad estimate).

Conclusion

The younger you start retirement planning, the more years your money will have to take advantage of the powerful concept of compound interest. If you are 50, you might have only 15 years before retirement. If you are 20, you have a good 45 years before retirement. In 15 years your money might double and redouble. In 45 years, the same investment and interest rate will double 6 times. Do the math. Take advantage of compound interest.