The Power of Compounding

Many people don't realize the power of compounding and the effect of time. Preparing for retirement is best done early in life rather than later.

Consider the hypothetical case of three people—Aaron, Bob and Carl. Aaron begins to save for retirement at age 20 and saves $2,000 per year for 10 years. Carl doesn't begin saving for retirement until age 40 and contributes $2,000 each year until he reaches age 65. Bob begins saving at age 30 and contributes $2,000 each year until age 65. Neither of the last two will have as much at retirement as Aaron, thanks to the power of compounding.

Assuming a growth rate of 8 percent each year, as the chart below shows, both Bob and Carl will contribute considerably more than Aaron, but will end up with from about $100,000 to $300,000 less at age 65—and Aaron can stop contributing at age 30. The reason is the power of compounding. It pays to begin saving early.