People who are far from retirement often widely misjudge the total savings they’ll need. A big reason for this is the pervasive impact of inflation over decades. We tend to assume a dollar is a dollar is a dollar. Not so. In 1970, the average cost of a new car was $3,900. By 1990 the average new car cost $16,000. Today the cost is well over $20,000. Let’s imagine that type of price inflation continues. It could drive the price of a car in 40 years to more than $100,000.
What $1,000 Bought in 1970 Now Costs $6,000
Here’s another way to view inflation. According to the U.S. Department of Labor what you could buy for $1,000 in 1980 costs you $2,867.63 today. This chart demonstrates the strong impact of inflation over time:
|A $1,000 in this year||Has the same buying power as this amount in 2014|
The counter punch to inflation is compound interest. Compound interest is interest calculated on both the principal and the accrued interest. Save $10 at 5% over time and you receive interest not just on your original $10 but also on the amount of interest that has built up. While inflation drastically reduces the buying power of your money, compound interest dramatically increases the buying power of your money.
Compounding takes advantage of the power of time to increase the value of your savings and investments. Your money in an interest bearing account grows. And grows. And that growth can produce impressive results.
How To Save $1,000,000
For example, imagine your goal is to save a million dollars. How much would you need to save each month? If you start at age 35 you need to save around $735 per month to have $1 million by age 65, assuming an 8% average annual return. But if you wait just five years and start at age 40, you need to save around $1,135 per month. That’s quite a difference. You can use the SEC’s calculator to plug in your current principal, monthly additions, years to grow and anticipated interest rate. In seconds you’ll know how much retirement savings that scenario would produce.
What if you could save $400 for retirement every month and earn 5%? If you only had 10 years to save, compound interest won’t help grow your retirement savings that much. But look how compound interest makes a large difference over 20, 30 or 40 years:
|Monthly Savings Earning 5%||Years You
|Total Retirement Savings|
Gene Offredi, CFP, RFC, Summit Investor Coach, Guilford, CT. Call 203.453.1017 or visit summitinvestorcoach.com.