THE POWER OF COMPOUND INTEREST

  TEACHING IDEAS

1. Be sure you explain these important assumptions that lie behind the example:  

   •  Contributions are put into an IRA (Individual Retirement Account), which means that capital gains and interest/dividends are not taxed as they accumulate.  (Note:  Since Roth IRA’s are funded with money that has already been taxed, distributions are not taxed when they are withdrawn, typically after retirement when income is lower. Traditional IRAs are funded with money that has not yet been taxed, so distributions are taxed when they are withdrawn.)

   •  Contributions earn 8%.  (While this rate is much    higher than average returns on more conservative    investments such as bonds (5%), savings    accounts, certificates of deposit, or U.S. Treasury    Bills (3.8%), 8% is reasonable to use.  In fact, the    approximate long-term return on common stocks    since 1926, a time period which includes the
      Great Depression, is about 10-11%.)

   •  Calculations are not adjusted for inflation.    Students should realize that at age 65, the real    purchasing power of $440,245 will be significantly    less due to the effects of inflation.  For example, if    we assume an average inflation rate of 3% over
      the time frame on the poster, the real, inflation-
      adjusted interest rate Investor A earns would
      really be 5%. (8% minus 3%)  The inflation-
      adjusted amount (i.e. purchasing power amount)
      at age 65 would therefore be $139,373 not    $440,245! However, students should also realize    that as inflation rises, their incomes also will rise;
      thus, contribution amounts could also increase
      beyond $2,400 per year.

2. Explain to students how the biggest absolute gain in portfolio value occurs during the later years.  For example, the Investor A portfolio increases from $299,623 to $440,245 from years 60 through 65 — a short span of time.  This is why it is so important to begin saving early in your life.  Later on, the power of compound interest really begins to work for you!  Of course, it isn’t always easy to save when you are young.  Income is usually not high and there are many “youthful” expenses, such as education, buying a first home, starting a family, etc.
3. Explain the importance of saving regularly. To their credit, Investors A and B both saved $2,400 each year ($50 per week). Saving this amount each month is not always possible; however, everyone should get into the habit of saving something each month, even if it is a small amount. As one gets older and income increases, the amount saved each month can grow.
4. Discuss the important implications of using different types of investments in your IRA. For example, there is a very large difference in the historical return on common stocks (11%) versus bonds (5%) and short-term savings instruments, such as 90-day treasury bills (3.8%). If Investor A invests in bonds at 5%, his final accumulation at age 65 will be $139,373. If he invests in “cash” (30-day treasury bills at 3%), his final accumulation at age 65 will be only $63,710. This is a far cry from the $440,245 one could earn from an 8% estimated return on common stocks, which actually have an average historical return since 1926 of about 11%. (If you earned 11%, your amount at age 65 would be $1,352,775!) This discussion will lead naturally into an analysis of the Financial Planning Pyramid poster, and the relationship between risk and return.
5. Explain the Rule of 72 , a simple way to determine how long it will take your investment to double. The Rule of 72: This rule says that if you divide the annual interest rate you expect to earn on an investment into 72 you will 10 know how many years it will take to double your investment! For example, suppose you put $1,000 in a savings account that pays a 4% interest rate. In 18 years (72 / 4) your investment will be worth $2,000. If you were really successful with your investment and could get a 12% annual return, it would take only six years to double your money.