Getting rich slowly using the power of compound interest

24 July 2017 by Supplied text

We’ve all heard the old proverb ‘you reap what you sow’.

Compound interest is just that, if you start early and make a concerted effort to save, your gains will be profound.

Certified financial planner Kerry Sutherland from Alexander Forbes Retail explains how the concept of compound interest works and why it is important.

“Due to the power of compound interest, saving is the one part of your life where you cannot procrastinate. Compound interest is the addition of interest to the initial sum invested, reinvesting this money for the next compounding period for the entire term of your investment,” Sutherland said.

As an example, the Naidoo’s decide to invest R1 000 per month for their child’s tertiary education in 18 years’ time, investing consistently from the time the child is born. Capital growth and interest are added back into the investment. At an assumed growth rate of 10% per annum, the value at the end of 18 years would be R600 500 and the total contributions would have been R216 000.

The Smiths only start saving for their child’s education when the child is 10 years old, and also require R600 500 in 8 years’ time to fund tertiary education. “They would however have to save R4100 pm for 8 years to achieve this, a total contribution of R393 600. By starting 10 years later, the Smiths have to contribute an additional R177 600 for the same final result.”

Sutherland said this example was amplified when it came to retirement savings, because this is usually a 40-year term.

“Based on a growth rate of 10% per annum, if one saves R1 000 a month, the capital amount after 20 years would be R759 300. If one saves R1 000 per month for 40 years, the value would be R6.3-million. At a draw rate of 6% per annum, the income at retirement on R759 300 would be R3 800 per month and on R6.3-million, would be R31 600 per month. This is before any taxes have been taken into account. If the income is coming from a retirement source income tax will be payable and if the income is coming from a discretionary investment tax on interest, dividend and CGT will be payable. The effective CGT rate would range between 7.2% and 18% depending on the client’s marginal tax rate at the time of withdrawal.

The total contributions for the client who saved for 20 years was R240 000 and the contributions of the client who saved for 40 years was R480 000, yet the difference in their values at retirement was a massive R5.5 million.

Sutherland says “Market volatility will occur, but the beauty of rand cost averaging, is that by consistently investing every month towards your investment goal one would buy the market at a different price every month. Looking back over all long-term time periods, markets have increased over time.”

For employees who are part of a company retirement fund, monthly contributions will be made to the fund either through salary sacrifice or employer contribution. “Usually, this is the cheapest way to save because your company will be able to negotiate better investment and administration fees than an individual. Should you begin with your company retirement fund at age 25, then 19% of your salary should be sufficient should you continue with this for the next 40 years and not cash in your funds on resignation or retrenchment, but rather preserve them. Should you start working later, then you would need to invest a higher percentage of your salary to compensate for your lack of compound growth in previous years.” A certified financial advisor would be able to do the calculations for you as to how much you need to save per month to reach your retirement goal.

Sutherland advises setting up a monthly debit order towards an investment as soon as one starts working. “This is an excellent way to save for a house, children’s education or towards retirement. You would get used to not having that money in your bank account every month and would budget accordingly. As your salary increases each year, you can build in an annual escalation to your debit order. The sooner you start the better.”