September 8, 2011
The Power of Compound Interest
Every entrant to the workforce should be subjected to the same questions posed to California undergraduates in a new experiment about how well people understand compound interest.
Better to show the math than to explain it. Franny and Zooey just started working. Franny immediately begins depositing $100 per month – $1,200 every year – into her new retirement account, which pays 10 percent interest annually. Zooey doesn’t start saving for 20 years, but he puts in $300 every month — $3,600 annually — and also earns 10 percent interest.
In 40 years, Franny retires with $584,222 in her account – more than double Zooey’s $226,809.
Asked to calculate these future savings on their own, 90 percent of the undergraduates had vastly underestimated the totals in the experiment by Craig McKenzie at University of California, San Diego and Michael Liersch at New York University. Yet, this mathematical calculation is central to the financial well-being of most Americans. In 2009, more than half of all households were at risk of not having sufficient assets to retire, according to Boston College’s Center for Retirement Research, which hosts this blog.
After testing their subjects’ knowledge, the researchers tested how they might respond if they knew the implications of starting to save early and benefitting from exponential savings growth due to compounding. Shown the impact it has, they became more interested in saving earlier (the students) or more (employees at a Fortune 100 company).
McKenzie and Liersch said that if employers showed new employees their potential future account balances, it “could substantially contribute to the welfare of retiring workers.”
This and related research on consumer financial behavior will be featured in the special November issue of the Journal of Marketing Research.
Thanks for your blogging. I like to see your thinking on retirement income. One of the most difficult things about earning retirement assets these days is the lack of interest/stock growth that persists and the risk to principal. The power of compound interest is only as strong as the actual reality of interest to be earned or stocks that increase in value. Certainly, no one is earning anything close to 10% now, and I think that discourages people from saving. But the principle still applies if someone is earning 1%.
It is frightening that 90% of college students can’t do this math exercise. If that’s the case, what are the chances of any financial literacy effort.
Now let’s modernize this example. The reason that Franny started depositing right away while Zooey didn’t is not because of any difference in income or ability to save– no it was because Franny was awarded a full freight scholarship while Zooey had to take out a huge student loan to obtain the same degree. So while Franny was accumulating savings immediately after starting work, Zooey was repaying that huge loan over 20 years. As soon as he paid it off, Zooey started saving– at triple Franny’s rate, but alas he can never catch up. Chalk it up to the “power of going deep in the hole to pay for your education”.
Are young people going to be told that if they save and sacrifice, they’ll end up no better off in old age because Social Security and Medicare will be means tested?
I had expected that to be the Democratic proposal, once the “no problem” denial was no longer supportable. Now that it is the Republican proposal as well, it seems inevitable.
But of course, all cuts in benefits must only affect those 54 and younger. Even though their incomes have been progressively lower on average than those who came before, they have “time to adjust.” And they can also pay back the money borrowed to ensure the same benefits for those older with more tax cuts.
I love your concept for the blog, but after reading one of your entries I have to ask: Where is anyone earning 10 percent (safely) right now. If you are younger and can handle some risk, perhaps a long-term stock plan might work. But if you are already in an age bracket where you cannot lose what you already have and may not earn much more – PLEASE TELL ME WHERE YOU CAN EARN 10 PERCENT!?!? This is a fantasy in today’s environment. I am in retirement age and may outlive my savings. I need real answers.
I agree with Tom. Where in the world would you be able to count on 10 percent year in and year out? But at the same time, it’s a hypothetical situation to demonstrate the power of compound interest. I like to think of it this way: instead of saying “I’m young enough to take the risk,” I would rather say “I’m young enough to not have to take the risk.” Starting compound interest at a young age (even if it’s 5 percent) will do much better for me than a risky mutual fund where I could potentially lose everything.
Nice article, I found another article that explains the situation a little better. Imagine you have two people: a 22-year-old and a 30-year-old.
Both contribute $8,000 a month compounding at 8%. How much would each have at age 68? The results are surprising.