Compounding interest: How the rich keep getting richer
We’ve all wondered how the wealthy seem to continuously amass more wealth (almost) effortlessly. What’s their secret? Short answer: compounding returns.
It’s widely rumoured – but unconfirmed – that Albert Einstein once said, “Compounding interest is the most powerful force in the universe.” It might be an urban legend, but it doesn’t detract from the truth of the message.
Compounding interest (also known as compounding returns) is a powerful force. And the good news? Compounding interest is not just for the wealthy. It’s a superpower that anyone can harness. Read on to learn how.
What is compounding interest (aka compounding returns)?
US founding father Benjamin Franklin said it best: “Money makes money. And the money that money makes, makes more money.”
Suppose you invest $10,000 in a fund growing at a 6% annual rate. After the first year, your balance will be $10,600: the starting amount plus your 6% return. From the second year on, you won’t be earning returns just on the initial $10,000, but on the full balance – including returns.
At the end of the second year, you will have $11,236 in your fund. At the end of the third year, you will have $11,910. After 30 years of reinvesting your returns, your balance will be worth over $57k after earning an annual return of 6% per year.
As the graph below illustrates, this growth isn’t a straight line going up. It curves and gets steeper. This means that the longer you stay invested (aka your money stays invested), the faster your savings grow.
Source: Calculation via calculator.net - based on initial investment of $10,000, invested for 40 years with an annual return rate of 6%, compounding annually.
Compounding interest and your KiwiSaver plan
If you’re a KiwiSaver member, you’re already benefitting from compounding interest. Every dollar you contribute to your KiwiSaver account gets invested and (unless you’re using your KiwiSaver funds to buy your first home) stays untouched until you turn 65 – earning returns on returns over time.
Here’s another interesting graph. As you can see, in the long run your contributions will account for just a relatively small proportion of your total KiwiSaver balance. The brunt of it will come from asset returns.
Assumes a 30-year-old earning $100,000 a year and contributing 3% to their KiwiSaver account, with their employer matching at 3%. This scenario is based on a $0 KiwiSaver balance with a starting salary of $100,000 growing at 3.5% per annum between the ages of 30 and 65 using a neutral kōura glide path. We have used the FMA prescribed returns for our growth assumptions.
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All equity funds are expected to generate a return after tax and fees of 5.5%;
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Our fixed income fund is expected to generate a return after tax and fees of 2.5%;
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Our cash fund is expected to generate a return of 1.5%.
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We assume 2.0% annual inflation, the mid-point of the Reserve Bank of New Zealand’s inflation targets.
Thinking of withdrawing early?
If staying invested is the key to making the most of compounding returns, what happens if you withdraw your KiwiSaver funds early – e.g., to buy your first home?
Essentially, you’d be taking fuel out of your ‘compounding-interest tank’. For example, if you were to pull $1,000 from your retirement account at age 35, you would not just lose that amount. Due to compounding returns, the future value of that $1,000 could be around $6,500 by the time you retire.
Of course, that doesn’t mean that withdrawing early is intrinsically bad. After all, if you use the funds to buy your first home, you’re still putting your money to work – just in a different market. But it’s important to be aware of the impact on your retirement savings.
Why it’s important to choose your KiwiSaver fund
Here’s another reason to take compounding interest seriously: it amplifies the difference in returns.
For example, on the surface, the difference between investment returns of 5.5% and 6.5% might seem minimal. But when compounded over decades, that seemingly minor gap can have a deep impact on the final balance.
Let’s say that today Jane invests $10,000 in a fund that delivers an average 5.5% annual return, while John invests the same amount in a fund delivering an average 6.5% annual return. In 30 years’ time, John’s balance will be $66,143 whereas Jane’s balance will only be $49,839.
This is why it’s so important to choose where you invest your money. For example, if you have a long-term horizon, you might be okay with taking a bit more risk. There will be more ups and downs with a higher-risk investment fund, but returns are also likely to be higher – allowing you to make the most of compounding interest in the long run. Yes, it might seem like a small difference today, but compounded over time it makes a massive difference.
Are you on track?
Like to know how much you’re on track to save? Use our digital advice tool to crunch your numbers in a few quick steps. Then, you can adjust the contribution rate in the calculator to check the difference it could make to your nest egg.
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Disclaimer: Please note that the content provided in this article is intended as an overview and as general information only. While care is taken to ensure accuracy and reliability, the information provided is subject to continuous change and may not reflect current developments or address your situation. Before making any decisions based on the information provided in this article, please use your discretion and seek independent guidance.
