Still young? Then tap into the magic of compound interest and save millions
Retirement is a long way away when you are in your 20s. That much is true. But learning about compound interest at a young age will go a long way to making your savings towards retirement not only easier, but far more effective.
Retirement may be 40 years away, and so you still have many years ahead to save towards retirement. This is true.
Let's say you don't start now, and then when you reach 45 or even 55 wake up to the fact that you need to start building your nest egg.
You sit down with a financial adviser and work out what you will need in retirement - maybe you need to save a total of R5-million. Let's assume you have enough money left over each month to really "pump" up your retirement savings and you reach your goal.
That would obviously be great, but for most people this is not the case.
However, had you started at 25 or even at the age of 35, a little bit of compound magic would have changed the whole scenario. The amount that you would have had to put away of your own money to reach that R5-million is far less. In fact, most of your R5-million would have been earned through investment gains.
In order to understand this better, look at the table below that was drawn up by Ultima.
The blue section is how much of your own money you paid in contributions towards your retirement plan. The orange bit is how much of the total R5-million was reached as a result of investment gains, or growth.
Hendri de Klerk, a financial planner from Ultima explains compound interest:
"Compound growth is best described as growth on growth much like the snowball effect. A snowball increasing the surface with every roll and the longer it rolls the exponentially larger it gets.
Compound growth is best described as growth on growth much like the snowball effect. A snowball increasing the surface with every roll and the longer it rolls the exponentially larger it gets.Hendri de Klerk - Ultima Financial Partners
"When it comes to a long term savings plan, like your retirement savings plan, you want to maximise on investment gains. Investment gains are essentially the compound growth part of your investment.
"If you start later in life and should you be able to fulfill your objectives, then it will cost more own contribution from your side and less investment gains, as provided by the growth of a well-balanced and actively managed portfolio."
So, now you know what compound interest is, and how it works, but how does that change your life?
Most employees in South Africa do not work for a company that offers a compulsory pension fund. This means that if you want to take advantage of compound interest in your retirement savings, you need to make some very responsible, but hard decisions. You need to set it up on your own.
This may seem easier said than done. We all know that the cost of living is sky high, and none of us earn as much as we want to. With this in mind, De Klerk offers ten tips for young people starting out in the world of work.
Ten financial priorities for people in their 20s.
1) Get a medical aid – medicine is expense when the unexpected happens and having the option to use private medical care is very important.
2) Save for retirement – we recommend that people save at least 10% of remuneration, but 15% would secure comfortable retirement. A more aggressive approach is advised.
3) Securing disability insurance in the form of an income protector that will pay you a monthly income in case you can’t work any more.
4) Pay off your study loan – many students today have a study loan to repay and dependent on the interest rate the level of priority might change.
5) Life insurance – especially for young married career starters. Life insurance becomes more of a priority as you have a family that is dependent on your income.
6) Short term cover for assets
7) Emergency fund – we always advise clients to have an emergency fund with at least three months’ salary value. An access bond or a call account linked to your bank account are easy ways to set up a solution.
8) Save for a deposit on your own property (future primary residence).
9) Ensure a valid will is in place.
10) Budget planning / spend tracking – it is important to be fully aware of your expenses and this can be tracked using a spend-tracking app linked to your bank account.