Understanding the power of compound interest shows the benefits of starting your investments and savings plan, preferably your retirement, early. Compound interest means that the interest of your investments will earn interest as well, thus, allowing you to build a bigger nest egg.

There are three key things that affects your retirement fund:

  • Time
  • Rate of Return
  • Contribution/Savings

Of all the three, time is the one that most of us wish we have more. The more time you have the less money you have to contribute to attain the same accumulated amount (assuming that the rate of return is the same throughout).

Here is a fictional case on how two newly graduates, who made different financial decisions, went through their lives. This is a classic example that most financial planners show their clients. Keep in mind that the 10% rate of return is just an assumption and the year end values did not factor in the effect of income taxes. The scenario assumed that both graduates would invest in a tax-deferred retirement savings account like an Individual Retirement Account (IRA).

Kobe and Shaq graduated from Los Angeles State University at the age of 22 and both started their careers earning $40,000 a year. Shaq understood the importance of saving early so he started investing $250 per month ($3,000 annually) towards his tax-deferred retirement account that earns a 10% rate of return as soon as he landed his first job.  Eleven years later, Shaq terminated his retirement contributions because he had already build up an accumulated total of $65,687:This nest egg would be good enough to grow to at least a million dollars during retirement age. The extra $250 would helped him achieve his other plans such as saving for a down payment for a house, non-retirement savings, or educational funds for the kids. 

On the other hand, Kobe, unaware of the value of time, procrastinated saving towards his retirement until ten years after. He would also saved $250 per month but he would need to continue doing this until he retires to catch up on his goal.

 

Shaq

      

Kobe

    
Age Cont   Total   Cont   Total
22 $3,000   $3,141   $0   $0
23 $3,000   $6,612   $0   $0
24 $3,000   $10,445   $0   $0
25 $3,000   $14,681   $0   $0
26 $3,000   $19,359   $0   $0
27 $3,000   $24,528   $0   $0
28 $3,000   $30,238   $0   $0
29 $3,000   $36,545   $0   $0
30 $3,000   $43,513   $0   $0
31 $3,000   $51,211   $0   $0
32 $3,000   $59,715   $3,000   $3,141
33 $0   $65,687   $3,000   $6,612
34 $0   $72,255   $3,000   $10,445
35 $0   $79,481   $3,000   $14,681
36 $0   $87,429   $3,000   $19,359
37 $0   $96,172   $3,000   $24,528
38 $0   $105,789   $3,000   $30,238
39 $0   $116,368   $3,000   $36,545
40 $0   $128,005   $3,000   $43,513
41 $0   $140,805   $3,000   $51,211
42 $0   $154,886   $3,000   $59,715
43 $0   $170,374   $3,000   $69.109
44 $0   $187,412   $3,000   $79,488
45 $0   $206,153   $3,000   $90,952
46 $0   $226,768   $3,000   $103,618
47 $0   $249,445   $3,000   $117,609
48 $0   $274,389   $3,000   $133,066
49 $0   $301,828   $3,000   $150,141
50 $0   $332,011   $3,000   $169,004
51 $0   $365,212   $3,000   $189,842
52 $0   $402,733   $3,000   $212,863
53 $0   $441,907   $3,000   $238,293
54 $0   $486,098   $3,000   $266,387
55 $0   $534,707   $3,000   $297,423
56 $0   $588,178   $3,000   $331,708
57 $0   $646,996   $3,000   $369,584
58 $0   $711,695   $3,000   $411,426
59 $0   $782,685   $3,000   $457,649
60 $0   $861,151   $3,000   $508,712
61 $0   $947,267   $3,000   $565,122
62 $0   $1,041,993   $3,000   $627,439
63 $0   $1,146,193   $3,000   $696,281
64 $0   $1,260,812   $3,000   $772,333
65 $0   $1,386,893   $3,000   $856,347

$33,000       $102,000    
       

                                

Legend: Cont - is the total yearly contributions Total - is the total accumulated year end value. The savings are based on the $250 per month contributions at a 10% annual rate of return.

Conclusion: Look at the difference in their accumulated total nest egg. Shaq contributed only $33,000 but he had $1,386,893 in total while Kobe, who contributed $69,000 more, had only $856,347. By investing early, Shaq had the luxury of terminating his contributions early and using the extra money to where he needed it the most: house down payment, emergency funds, educational funds, regular day-to-day expenses or other non-retirement investments.

This scenario shows you why you should start saving for retirement as early as you can.

(Post for illustrative purposes only. Please read the disclaimer page!)