Paul Leonard CFP®, Regional Head: E Cape, Citadel
Let’s say that Bob is starting in his first job and he plans to save R500 per month.
If he received a return of 10% per year, Bob would have about R3,100,000 saved in 40 years’ time. (For simplicity, the amounts in this article have been rounded down.)
If Bob stopped saving after just 30 years then the amount amassed would be only R1,100,000, which is about a third of what it would have been at year 40. If he stopped saving after 20 years, the value of his savings would be only R380,000, about a third of what it would have been after 30 years. And if he stopped saving after 10 years, he would have only R100,000; less than a third of what he could have had after 20 years.
It seems amazing that in this example, the level of Bob’s savings trebles every ten years. How can that be?
The answer lies in the amazing power of compounding. By leaving his money invested, Bob is able to earn income on the income that his savings generate. The longer that this is allowed to take place, the greater the returns. This is the single most important lesson for investors and enables investments to grow exponentially over time.
But let’s look at this a different way.
If, after ten years, Bob changed jobs and this was his pension fund investment, the Human Resource manager would have called him to ask what he wanted to do with the money in his pension fund. He would have three options:
- Transfer it to his new employer’s pension fund,
- Transfer it to a retirement annuity or preservation fund in his own name, or
- Have the money paid out to him.
Most people choose option three and have the money paid out. Like Bob, they ask for the value of the fund. In Bob’s case, it is R100,000. He may compare that to the potential R3,100,000 that he could have had after 40 years and think that R100,000 is worth nothing in comparison to the potential end value. He may think that if he takes the R100,000 after the first ten-year period it won’t make much difference, as he plans to carry on saving R500 per month for the next few decades.
But Bob is missing an important point. He will in fact not continue saving at the same rate the next few decades as he has to repeat the first ten-year period. This means that he is not cutting the first ten years of compounding off his money, he will be cutting off the last ten years. In those last ten years the value of his money grows from R1,100,000 to over R3,100,000. This is a difference of R2,000,000. By spending the R100,000 after ten years, he is fact not losing R100,000 – he is losing the R2,000,000’s worth of growth that he could have had.
The lesson from this is example is that whenever Bob changes jobs, he should do what he can to preserve his retirement savings.