Compounding: The Eighth Wonder of the World

by Mitchell J. Smilowitz, CPA

Retirement is the most expensive purchase you’ll make in your lifetime so it’s crucial that you save enough to afford the 20 to 30 years you’ll likely spend retired.

How much of your gross income (your income before paying taxes) should you be saving each year in order to achieve financial security when you get older? 

The experts tell us you need to have a “nest egg” of 8-12 times your final annual salary when you retire in order to maintain your pre-retirement lifestyle.  Of course the amount varies based on when you plan to retire, where you plan to live, your health, whether you plan to continue working part-time, etc. 

The Eighth Wonder of the World

One of the most important factors in determining how much you need to save is when you start saving. Why? It’s all about compounding.

The concept of compounding is one of the most powerful ideas in personal finance.  Einstein reportedly commented that “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.”

The basic notion is simple. Compounding is the result of reinvesting the interest and dividends earned on your principal (for instance, earnings on contributions to your JRB retirement account). The income you earn in the future is based on the principal plus the earnings you accrued in the past.  For example, if you earn 5% interest annually on $1,000, your account grows by $50 to $1,050 after a year.  If you earn 5% on $1,050, your account grows by $52.50 and is now worth $1,102.50.  With compounding, therefore, your balance doesn’t just grow; it grows faster because future earnings accrue on the interest and dividends already earned.  

Compounding has its biggest effect when calculated over long periods of time. The following examples demonstrate the importance of starting early in realizing the full power of compounding to help you reach your retirement goals.

Why Start Early - Two Examples

Rabbi Sarah begins saving 10% of her annual $50,000 salary – a $5,000 contribution to her JRB retirement account – as soon as she accepts her first position at age 30.  If we assume her salary increases 2% a year, she continues saving 10% of her salary for the next 40 years (until she retires) and earns an average of 5.5% annually on her investments, she will have amassed over $1 million (specifically, $1,014,208) by age 70.

On the other hand, Cantor David begins saving 10% of his $100,000 salary – a $10,000 contribution to his JRB account – beginning at age 45. Assuming his salary also increases 2% a year, he continues saving 10% of his salary for the next 25 years and also earns an average of 5.5% annually on his investments, he will have accumulated only $708,270 by age 70 despite his larger annual contributions.

What have we learned?  Even though Rabbi Sarah’s salary was half of Cantor David’s when she began saving for retirement, and she contributed about half as much as he did each year, the fact that she started at an earlier age allowed her to accumulate over $300,000 more (42% more) for retirement than Cantor David.  The reason?  Compounding!  Having started saving at an earlier age than Cantor David allowed compounding to work for a longer period of time resulting in a substantially larger “nest egg” when Rabbi Sarah retired.

What Can You Do?

Start early – or as soon as possible so you can take maximum advantage of compounding.

Think about ways to make savings automatic. Talk to your employer’s payroll administrator about setting up automatic contributions to your JRB account from your salary. Set up the highest contribution you can afford in order to reach your savings goal.

Increase your annual contributions to your JRB retirement account by 1% each year until you are saving 20% of your gross salary annually.  Again, the experts tell us that saving 20% of your salary each year is what you will need to afford a comfortable retirement. Contributing an additional 1% each year likely will not affect your current lifestyle but it will have a significant impact on your lifestyle in retirement.

Remember, your contributions through payroll are tax-deferred. If your federal and state income tax rate is 30%, it only costs you 70 cents to invest $1. If your tax rate is 35%, it only costs you 65 cents to save $1.  When somebody gives you $1 for 70 or 65 cents, that’s a good deal!  Therefore, pre-tax contributions through payroll are an incentive to save.

To learn more about how you can take greater advantage of compounding, contact the JRB at 888-JRB-FREE (572-3733) or staff@jrbcj.org.