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Compounding: The 401k Equivalent of Cruise Control

July 30
00:03 2013

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 1055704_73380204_coins_graph_300amazed 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,”,  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.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


  1. Ted Leber
    Ted Leber October 10, 00:43

    Please don’t forget to always address teachers who are hit with 403(b) fees–often as high as 225 basis points. With no matching, there is no good reason for school districts to even allow companies on the property to sell variable annuities. Yet they do. And school districts hide behind what they call “hold harmless” agreements. Please, point me in the right direction for a piece you have written about this injustice..

  2. Joel
    Joel October 10, 12:30

    I am more outraged than my friend Ted because these commissioned-based products are charging more like 325 bp when the expense ratios and administrative fees are combined.

    That said, these predators have been roaming the halls of America’s k-12 school system since January 1, 1959. This abuse must stop. Here is the result of this half century of abuse in one state, New Jersey.

    JOEL L. FRANK, PO Box 148, Marlboro, NJ 07746, 732-536-9472,

    March, 2012

    Do you have any idea how the costs associated with investing impacts the growth of your TSA/403(b) investment account? Consider the examples of Teachers A and B.

    Assumptions: First year salary of $30,000 with annual increases of 3 percent. 10 percent of salary is invested each year. The investments are made for 40 years and earn 8 percent a year. Teacher A invests with the State-administered TSA/403(b) Plan labeled the Supplemental Annuity Collective Trust (SACT). After 40 years the account is worth $1.1 million. Teacher B invests with one of the commission-based investment providers found on the website of the
    Department of Community Affairs–Division of Local Government Services at:
    After 40 years the account is worth $700,000.

    Why the massive difference in accumulations? With the SACT, Teacher A’s account is credited with the entire 8 percent return because the State pays all costs associated with maintaining the account. Teacher B, on the other hand, invested with one of the TSA sharks that charge about 2.2 percent a year. The 8 percent return, therefore, is reduced to 5.8 percent. The difference after 40 years of investing is $400,000.

    Since its inception in 1963 the SACT has offered just one investment option, a common stock fund. It’s hard to comprehend how such glaring negligence can continue, unchecked, for almost half a century. Such flagrant breach of fiduciary responsibility on the part of the SACT Trustees is the only reason why each of the 565 school districts have farmed out their own, high pressured, commission-based TSA plan to insurance companies and mutual funds.

    Having said that, if it is sound public policy for all school districts to be affiliated employers with the State-administered, Defined Benefit Pension Plan labeled the Teachers’ Pension and Annuity Fund, why do we have 565 school districts farming out their own high pressured, commission-based TSA/403(b) plan to insurance companies and mutual funds when there is a State-administered TSA/403(b) Plan? For nearly 50 years the SACT, with its solitary investment option, has been the commission based TSA/403(b) sales shark’s most cherished and reliable ally.

    While it’s utter nonsense for each of the 565 school districts to sponsor their own TSA plan, until the SACT Trustees adopt a diversified investment lineup teachers will continue to avoid the SACT. Unfortunately, they will also continue to be severely mauled by the high pressured, commission-based TSA/403(b) investment companies that have been, since 1963, sanctioned by their employing school districts. 565 high pressured, commission-based TSA plans when a State-administered TSA Plan has been available for nearly half a century. A colossal breach of fiduciary duty.

    The SACT must offer more than a solitary common stock fund. See: Deferred Compensation Plan
    of the City of New York at:

    For nearly 50 years New Jersey has been the national poster-child for the sale of
    high pressured, commission-based investment funds to its public school teachers.

  3. Ted Leber
    Ted Leber October 10, 13:40

    A friend of mine commented to me the following. Your readers should know and understand:

    “Please keep in mind that the average variable annuity is costing the American public in excess of 3 percent when the Expense Ratio and Administrative Fees are combined. These fees are charged with equal vigor to purchasers of after-tax deferred variable annuities or to variable annuities purchased under section 403(b) of the IRC.”

  4. Joel
    Joel October 10, 18:20

    The 403(b) variable annuity sales shark that roams the halls of the nations k-12 public schools carries two large envelopes. One is labeled 403(b) applications and the other is labeled 457(b) applications. You see the public school employee is allowed to buy two supplemental retirement savings plans. So why not have the 403(b) sales shark sell the same variable annuity under 457(b)? Now, that’s being efficient!

    Having said that, the combined maximum contribution one can make for 2013 is $35,000. I trust you see how these sales wizards sport “earnings” in excess of $350,000 a year. No wonder the broker/dealer community is fighting like hell in front of the SEC to protect its exemption from the Fiduciary Standard.

  5. Ted Leber
    Ted Leber October 19, 12:32

    Dear Mr. Carosa,
    Why do you even have a comment section if you will not address the comments and shed light on the problems associated with the high cost of 403bs and the retirement plight of preK-12 community? Just point me in the right direction on articles you have written about this. Please

  6. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author October 20, 16:19

    Thanks for asking. I’m surprised no one has asked this question before.

    I will answer via comment if, like your comment, I feel it important for me to respond as editor. Generally, though, I try not to interfere with comments because I don’t want to give the impression the comment space is edited. I would hope that, short of spam, selling, or nasty personal attacks, readers feel they are allow to say anything. Regarding the specifics of where can you find articles addressing the high costs of 403b plans, I’m afraid to admit we only have a couple of articles that mention that (search the site by “403b” to find them). We have referenced articles in other publications in our weekly “Trending Topics” Summary (appears every Monday morning). I agree the issue you mention is worth discussing. Perhaps we can figure out a way to do a specific story on the issues surrounding 403b plans. To be honest, though, going forward, as regulators nudge 403b plans into the 401k molds, each will be exposed to the same issues.

    I encourage you to say more on this topic either through this thread or via directly email (see “Contact Us” tab on the site’s top navigation bar).

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