NCPA - National Center for Policy Analysis

The Magic Of Compounding

October 12, 2000

Compound interest is a powerful force that can work for savers or against consumers, say analysts. And if younger workers were allowed to designate a prudent investment fund in which to deposit a percentage of their Social Security payroll taxes, through the magic of compounding they would have a much larger monthly income during retirement -- or an account balance that could be passed on to their heirs.

Savings set aside for retirement in a 401(k) mutual fund, for instance, earn interest both on the amounts contributed and on the interest or earnings that are reinvested. By contrast, consumer credit card debt can take years to pay off, because consumers who don't pay off their cards will pay interest on both the amounts they charge and on the unpaid interest owed.

Compounding can best be demonstrated with a long-term investment such as retirement savings.

  • A young worker who invests $800 in his retirement account each year and earns 8 percent a year will contribute a total of $34,400 by the time he retires at age 67; but his whole investment will have grown to $284,760.
  • With an employer match, he will have $569,520 at retirement.
  • Another young worker investing only $500 a year and earning 8 percent interest will actually contribute only $23,000 by age 67; but her whole account will have grown to $225,950 by the time she retires.

You can see how you would fare with a personal retirement account and how it compares to your expected Social Security benefit by visiting the NCPA's Social Security Calculator at http://www.mysocialsecurity.org.

Source: Matt Moore (policy analyst), "The Power of Compounding and Social Security," Brief Analysis No. 343, October 12, 2000, National Center for Policy Analysis.

For text:

http://www.ncpa.org/pub/ba343

 

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