The magic of compounding Putting time to work on your retirement savings When you invest in something that earns a rate of return, it takes advantage of compounding — the ability of an asset to generate earnings, which can be reinvested to generate more earnings. The impact of compounding can be startling. It is possible that the growth in your investment over time may be more due to compounded earnings than to how much money you contribute. The key is to start early Consider this hypothetical example of two investors who are the same age, earn the same salary and face the same choices about saving and spending. Investor A starts saving at age 25 and contributes $200 per month to her tax-deferred retirement account. She continues contributing $200 per month for her working lifetime to age 65 - a total of 41 years. Investor B waits 10 years, until age 35, to start saving for retirement, figuring he can catch up by contributing more. He invests $400 per month (twice as much as Investor A) for 31 years until retirement at age 65. If both investors earn 7% returns compounded monthly the results are as follows.     Investor A   Investor B Contributions   $200/month starting at age 25   $400/month starting at age 35 Total contributions at age 65   $98,400   $148,800 Retirement fund value at 65 with 7% monthly compounding   $565,391   $528,222 Earnings   $466,991   $379,422 This hypothetical example is for illustrative purposes only and is not intended to reflect the return of any actual investment. Investments do not typically grow at an even rate of return and may experience negative growth. From this example you can see that investor B never catches up and the difference is substantial. In fact, many people faced with Investor B's situation have trouble catching up because a much larger chunk of a monthly contribution is required if saving and compounding have been delayed for 10 years. How compounding works Monthly compounding example: Start with $2,000 at 6% interest: End month 1 — $2,000.00 x .005 (.06/12) = $10 = 2,010.00 End month 2 — $2,010.00 x .005 = 10.05 = 2020.05 End month 3 — $2020.05 x .005 = 10.10 = 2030.15 End month 4 — $2030.15 x .005 = 10.15 = 2040.30 End month 5 — $2040.30 x .005 = 10.20 = 2050.50 End month 6 — $2050.50 x .005 = 10.25 = 2060.76 End month 7 — $2060.76 x .005 = 10.30 = 2071.06 End month 8 — $2071.06 x .005 = 10.36 = 2081.41 End month 9 — $2081.41 x .005 = 10.41 = 2091.82 End month 10 — $2091.82 x .005 = 10.46 = 2102.28 End month 11 — $2102.28 x .005 = 10.51 = 2112.79 End month 12 — $2112.79 x .005 = 10.56 = 2123.36 In this example, 6% earnings are accumulated monthly and reinvested in the principal. As the principal increases, it produces higher earnings each month. This compounding effect requires time, and the longer and the more consistently you invest the more substantial the benefit. How to achieve compound growth Interest can accrue on interest When returns from money market savings accounts or certificates of deposit are reinvested, these earnings can also produce interest. Cash dividends reinvested can purchase more stock More shares of stock can increase your dividend payment. Interest income can be reinvested in principal Growing the principal investment on a bond can produce additional earnings. This is allowed on certain bonds and the rules vary. An investment professional can answer questions Understanding all of your investment options and the impact of compounding is important when planning for retirement. Invest smart. Turn to a professional. Copyright © Russell Investments 2009. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an as is basis without warranty. Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Securities products and services offered through Russell Financial Services, Inc., member FINRA, part of Russell Investments. For information on the Financial Industry Regulatory Authority, go to www.finra.org. First used: October 2009 RFS 2398			Related articles Saving for retirement The high cost of borrowing from your retirement Developing your investment strategy Tax strategies   Printer friendly version of this page

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