Compounding: The 401k Equivalent of Cruise Control
For retirement investors, the power of compounding, most particularly tax-deferred compounding, performs the same way cruise control does for a car. Once you get into first gear – once you’re saving at the right rate – you’ll be amazed how compounding can really turbocharge your asset growth. Although he never actually said it, it’s easy to believe that a genius like Albert Einstein is attributed with saying “Compounding is the greatest force in the universe.” There weren’t any 401k plans around in the days of Einstein. Still, if he were alive today, he would be cited as saying “If compounding is the greatest force in the universe, tax-deferred compounding is a supernatural force.”
As alluded to in a previous article, (“The Retirement Saver’s Secret (as in ‘Under Appreciated’) Weapon,” FiduciaryNews.com, July 9, 2013) most financial professionals use the power of tax-deferred compounding as the leading reason to lure employees to save for their retirement. But, as mentioned in that article, people would rather have instant gratification than deferred gratification. Compounding – as powerful as it is (and we’ll show its power in a moment) – remains a deferred gratification. People simply must be told first that tax-deferred savings will give them an immediate increase in net pay. This is the hook that convinces them to save today, right now, without delay. That’s why it’s called “First Gear.”
Of course, once you’re comfortably into first gear, then it’s time for second gear. That’s when we start talking about the awesome muscle of tax-deferred compounding. Traditional compounding alone means earning money on your earnings, not just your savings. “$1 that gets 10% will be $1.10 in year two if you receive 10% it will be $1.21 which will continue for 40 years,” says Pete Marriott, Managing Director at Trinity Retirement Solutions, LLC in Charlotte, North Carolina.
Add to traditional compounding the advantages of tax-deferred compounding, and things really start to add up.
Dan Palmer, a financial advisor for Rehmann Financial Group in Fort Wayne, Indiana, says “The last item we show is accumulation of those contributions over 30 years. The amount that has come out of their pay is by far the smallest part of the balance. Most of the balance is the match and compound earnings. We have found when we explain it this way to participants it motivates them to contribute at least up to the match level.”
“I have found that in addition to explaining these advantages, an illustration is very helpful,” says Rob Clark, Partner of MPC Wealth Management in Orlando, Florida. “For example, if two investors each saved $1,000 a year for the next 30 years and both earned 8%, the investor with the regular taxable account would have approximately $89,500 assuming the investor is in the 25% tax bracket. While the investor that’s saving the same amount assuming the same return in a tax deferred account will end up with approximately $132,000 ($106,800 after taxes on the earnings).”
“Over time, compounding can snowball and really add up,” says Sandy Arons of Arons and Associates in Brentwood, Tennessee. “The key is to allow enough time to let it go to work.”
Lastly, compounding also give us that famous rule, the “Rule of 72.” As Arons explains, “To use the rule, simply divide 72 by the expected rate of return. For example, if you expect to earn an average of 8% over time, the Rule of 72 gauges that your investment would double in approximately nine years.” Unfortunately, lest you think things too easy, this rule only applies to lump-sum investments, not periodic investment plans such as those in 401k plans. But it is a close-enough approximation.
We’ll see how participants can use compounding to their surprise advantage in a later article, but for now, it’s important participants embrace the idea that compounding puts their retirement savings on cruise control. It makes it easier to attain their goal and becomes more powerful over time.
In a way, tax-deferred compounding is the retirement saver’s silent partner on the road to retirement success. We’ll talk about their more substantial partner in a future installment.
Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. The book also contains a series of chapters on how to create an investment policy statement that defines a set of menu options consistent with the concepts outlined here.