Ask people the following question: “You have a small worm, 10mm long, which grows at only 10% each day, how long will it be after one year?”
Based on intuitive assumptions to allow for compounded growth, you will likely get answers ranging from a metre to a couple of kilometres. The correct answer would in fact be 12,8-billion kilometres — more than the distance from the sun to Pluto … and back.
The disturbing reality is that most people plan for retirement using similar inaccurate intuitive assumptions about the effect of compounded returns and as a result, they miss out on significant potential retirement benefits.
Illustrative example: That unbelievably pricey first car
Sam and Pete are both 23 years of age and have just started their first decently paid jobs. Pete decides to use this “financial freedom” to purchase his first new car, a bright red hatchback with a 1,8-litre fuel-injected turbo motor.
The car costs R300 000 in total and in order to minimise the monthly cash flow, he finances the car over five years with a 45% residual. Including insurance costs, Pete’s monthly expense on his new car is R6 000.
Sam is tempted to do the same, but does the sums on compounded returns and decides to stick with his old varsity Beetle for a while, rather investing the exact same amount of money in an equity portfolio and leaving it untouched to grow until retirement.
After five years, Pete is surprised to find the trade-in value on his red hatchback equalling his outstanding residual and decides to buy a new car. He has made no net asset gain from his five years of instalments, but since he also didn’t have the savings needed to pay the residual, he decides to trade in the red hatchback and buy a new car.
Sam buys the exact same new car as Pete and their new car instalments are the same. If from that day forward their purchasing decisions, lifestyles and monthly expenses are identical, the difference between their retirement savings would come down to Sam’s decision to delay the first purchase of a new car and invest that money in an equity portfolio.
If equities return 6% in real terms, as they have for the last 100 years and inflation averages 6% as it has for the last 10 years, then at the retirement age of 63, Sam will have R30-million more than Pete! This means that at age 63 Sam will have the equivalent purchasing power of R3-million today.
Poor Pete! Who knew that his first hatchback would turn out to be SO expensive?
The early bird does indeed catch the worm
The above scenario is not far-fetched. It represents a common choice made every day and the assumption on equity returns is realistic. Real growth of 6% per annum will cause every R1 invested at age 23 to grow to more than R10 in real terms at age 63.
In other words you will only have to contribute 10% of the final purchasing power of your retirement savings, compounding will give you the other 90% for “free”. In comparison, by age 63 every R1 invested at age 43 will have grown to just over R3 and every R1 invested at age 53 will have grown to only R1,79 (both in real terms).
As with the length of the worm, most people severely underestimate the future value of early saving and consequently make retirement planning mistakes.
Late savers argue that they’ll spend early on in their careers while their incomes are relatively low, and once their incomes have increased later in life, they’ll make up for it with disproportionate saving. Their expectation is that significantly increased saving later in life will offset the much lower savings. However, every cent saved at an early age benefits so much from compounding, that for most people it is nearly impossible to replicate the same value through later savings.
Furthermore, later investments face bigger risks from market timing. As equity returns are volatile, entering the market at a high point could detract meaningfully from short- to medium-term equity returns (the past 10 years in the UA being a good example). However, that risk decreases for long investment periods, providing yet another reason to invest early.
Early life spending does the same to your retirement savings pool as what an early bird does to a worm — destroys it. Our little 10mm worm will only grow to Pluto and back if it grows at a compounded rate for long enough.
However, if it is pecked in half or gobbled up altogether by the proverbial early bird, it has no chance of reaching the stars.
Where do you want your retirement funds to grow to?
Fred White, is head of asset allocation and macro research Sanlam Investment Management (SIM)
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