Compound interest and the rule of 72 trump the rule of living in the here-and-now

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The notion of saving to ensure a decent standard of living in old age is, for many young people, as alien as the idea of not being organically attached to a Smartphone. The very terms ‘old-age pension’ and ‘lifetime savings’ are anachronisms to those enjoying the freedom of living in the here-and-now.

The irony, though, is that many young professionals’ ‘I-must-have-it-as-soon-as-possible’ approach to life can also be their most effective approach to securing their late-life circumstances, thanks to the an extraordinarily powerful idea that they may have slept through in their maths class: compound interest. Albert Einstein called compound interest the eighth wonder of the world (“He who understands it, earns it; he who doesn’t, pays it.”).

Compound interest enables young people to accumulate much more wealth by simply starting to save earlier, because the interest accumulated on their early contributions is reinvested and itself earns more interest. Consequently, a few years of contributions to a retirement plan early in a career are equivalent to many more years of contributions starting from later in that same career.

By way of example, if we assume a constant annual contribution of one euro, dollar or pound to a savings account, and a constant interest rate of 7% a year, Jean, who starts saving upon getting a job after college and who stops saving at 30 will end up with about the same pension pot as John, who starts saving at 30 and continues to do so until retiring at age 70!

Financial planners often impress upon their clients the power of compound interest by quoting them the Rule of 72: with annual compounding, a euro, dollar or a pound invested at a constant interest rate of r% per annum doubles to two euros, dollars or pounds in approximately 72/r years. At 7% interest, money doubles every 10 years, while at 10% interest, it doubles every 7 years.

The Rule of 72 applies to retirement savings as well[1]: an investor investing one dollar, euro, or pound each year over the course of her working life at a constant interest rate of r% per annum will eventually find that approximately half the value of her retirement savings can be attributed to the first 72/r years of contributions.

This result, while simple, seems not to be well known, and has repeatedly proven useful when counselling young people on the importance of saving for retirement from an early age. Whether or not you understand the mathematics behind the Rule of 72, the fact is that compounding is an extraordinarily powerful thing, and you can apply it to your own benefit with ease

[1] “The Rule of 72 For Lifetime Savings”, Thomas K. Philips, Journal of Investment Management, Vol. 8, No. 4, (2010), pp. 1–4 © JOIM 2010

Click here to be redirected to the website of the Journal of Portfolio Management where, upon completion of an application form, you can access the Journal of Portfolio Management website.

This post refers to a  white paper written by Tom Philips called “The Rule of 72 for Lifetime Savings” Each year a number of white papers are published by the Thought Leadership group at BNP Paribas Asset Management. These white papers articulate the views and research of teams from across our investment partners on issues that are shaping investment thinking. Our white papers seeks to set out the intellectual basis of our approach to investing. They underpin much of the rational within our investment processes. Click here to access to a number of white papers recently published within the framework of our Thought Leadership group.

Thomas Philips

PhD, Global Head of Front Office Market

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