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.