Tuesday 18 September 2007

The Early Bird Gets a Bigger Worm

You often see the example of "Dick" and "Jane", the model savers. Jane starts saving $1,000 each year (increasing the amount each year in line with inflation) from ages 21-30 and then stops. Her savings are invested where they achieve a "real"(after inflation) return of 6%. When Jane reaches age 65 she finds that the $10,000 she invested has grown to over $100,000 (ignoring any taxes) - the magic of compound interest over a long time.

By comparison, Dick doesn't start saving until he reaches 35, but keeps saving $1,000 each year until he hits 65. In total he pours $30,000 into his savings account, yet his final investment account balance is slightly less than $84,000 even though he saved more than Jane and earned the same rate of return. This is often used as an example of why it is important to start saving as early as possible for retirement...

What I find even more interesting is the case of Baby X, whose parents put $1,000 into an account for their baby at ages 1, 2 and 3. If this investment earns the same real return (6%) as Dick and Jane, it will have grown to $118,000 by the time X hits 65.

The numbers get really impressive if you look at investing $1,000 each year for a kid from ages 1-10. This is one of the reasons I'll keep driving my seven-year-old Ford Festiva for another five years rather than upgrading to a newer model - it makes more sense for me to put $1,000 each year into each child's superannuation account than moving to a newer model car that will lose that much each year in extra depreciation alone. If nothing else it will mean that they won't need to save extra for their retirement and will be in a better position to pay off a home loan.

It's also a good reason to encourage kids to earn some money and contribute into their own superannuation account - they'll get the $1,500 government co-contribution to help them get ahead. The other benefit of saving for kids via a superannuation account is that the earnings are only taxed at 15%, rather than the exhorbitant rates than can apply to kids "unearned income".

Just as an example, saving $1000 pa from ages 1-10, then $1000 plus $1500 co-contribution from ages 11-20, would result in an account balance of around $778,000 by age 65!

Copyright Enough Wealth 2007

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