Compound interest and Social Security

This Tech Talk column originally appeared in The Exponent (University of Alabama in Huntsville), Vol. 32, No. 22 (March 1, 2001) and was later reprinted on January 31, 2002. Digitized issue: UAH LOUIS archive. Reproduced here courtesy of that archive.

Do you want to know an easy way to get rich? Will Social Security even be around when it comes time for you to quit work for good, kick back in your easy chair, and play Canasta on Friday nights? Everyone wants to get rich, so the former question is a no-brainer. The answer to the latter question is probably no, though, and that’s why government continues to force young workers to carry an unfair share of the nation’s economic burden. People in the “traditional student” age range SUCK when it comes to living up to our duty to vote while nine out of ten registered seniors vote at every opportunity. It’s no wonder that seniors get all the attention, but that’s another article in another section.

The opponents of President Bush’s proposed tax cut like to point out that the wealthiest one percent of Americans will receive a large portion of the total cut. Be that as it may, did you know that, in terms of financial potential, younger people are exponentially wealthier than older people? Of course, it would be much nicer to be fifty and rich than twenty and broke, but there’s no reason, other than death and taxes, that the broke twenty-year-old couldn’t be at least as wealthy by the time he’s fifty.

Those of us who can remember back to fifth or sixth grade can recall the simple lesson of compound interest. Say you have $100 in a savings account that earns interest at 5% annually. If you don’t touch it, the balance after a year will be $105. The magic is that next year you’ll earn interest on the interest: 5% of $105 is $5.25, so your balance after two years will be $110.25. The property of multiplication of real numbers gives a much nicer formula: $100 × (1.05 raised to the nth power), where n is the number of years you let your money grow. After fifty years, your balance will be $1,146.74.

Admittedly, eleven hundred bucks isn’t all that impressive after fifty years, but it gets worse. For one, Uncle Sam (he’s really more like a mob boss, so let’s call him Don Sameone) is going to extort his cut every year. Then there’s inflation, the force that erodes the purchasing power of your money over time. When you throw in taxes and 4% inflation, your money ($1,146.74) will be worth about $135 in today’s dollars. Ouch.

Earlier, I mentioned that young people are exponentially wealthier in terms of potential. There are a few obvious ways to increase your end balance. You can start with a larger initial deposit and continue to augment it over time. You can find an account that bears interest at a higher rate. The way to really juice your bottom line is to let your money grow for longer periods of time. Most of you reading this article have at least thirty years before retirement. RETIRE?! Yes, you read correctly. The earlier you start planning and saving for retirement, the better off you’ll be and the less likely you’ll be to depend on Mama Government to provide for you and your family in the twilight years.

Almost any decent benefits plan will include a 401(k) or its cousin 403(b). A 401(k) plan lets you take a set portion of your paycheck, deposit it in an account in your name, and invest in the stock market. “Aren’t there already enough deductions from my paycheck?” you’re probably thinking. The benefit is that Don Sameone can only extort his cut when you make withdrawals, so your money grows on a tax-deferred basis! (Remember how dramatically taxes ate into the previous example?) It gets better: good benefits plans include an employer match where your boss kicks in some percentage of your contribution up to a certain limit. Put simply, this is FREE MONEY! Plus, by taking out money before taxes (and before it hits your bank account—you’ll never miss it), you’ve reduced the income that you have to report to the Don and reduced your income tax.

Let’s do an example. Say you finally get your degree and land a job for $30,000 a year. You put 6% of your salary into a 401(k) and your employer matches 3%. If you never get a raise, your money will be worth about $166,000 or about $83,000 of today’s dollars after thirty years. After forty years, you’ll have $305,000, or $117,000 of today’s dollars. This example assumes 4% inflation and the same 5% interest. An investment that only earns 5% annually over forty years is pretty crappy. Historically, the S&P 500, an index of America’s 500 biggest companies, has returned about 11% annually, so your nest egg would be even larger.