Monday, March 18

2. Retiring as a Millionaire

MillionaireSo you'd love to have a million dollars in savings when you retire? A million is still a magic number, even if it won't buy what it would in 1970, say. In fact, based on your planning above, you may have discovered you'll need more than a million. But a million is certainly a number to inspire retirement planning.

Thanks to the power of the time-value of money and compounding, becoming a millionaire is an achievable goal even if you make a modest income, as long as you start early—preferably in your 20s. If you start later, you can still achieve millionaire status, but you will have to make larger contributions to your retirement savings.

The word time-value is a short way of saying that the longer the time you have to invest, the greater the accumulated returns on the money invested. Because of the power of compounding, the more years you have to invest (wisely, of course), the more money you will make.

Compounding occurs when the return that an investment has earned is added to the principal and then the new total begins to earn. The process is best understood in interest-bearing financial instruments which earn a certain amount of interest that is calculated (or compounded) at certain intervals (such as daily, monthly, annually).

Let's say you have a money-market fund or a certificate of deposit earning a certain percentage compounded daily.Each day the interest earned on the principal is calculated, that interest is added to principal to form a new principal on which interest will be calculated the next day. . .and so on. Earning interest on interest makes the overall amount of money grow faster.

The same concept of compounding applies to other forms of return on investments (such as dividends or capital gains on stock). When they are reinvested, they continue to earn along with the original investment.

Over time, because of the power of compounding, a difference in average return of only a few percentage points can make a big difference in how much your retirement savings grow. Take a look at the following table to see what happens to $1000 at various rates of return (compounded annually).


Examples of the Power of Compounding on $1000

Year 5% 7.5% 10%
1 $1050 $1075 $1100
5 $1276 $1436 $1611
10 $1629 $2061 $2594
15 $2079 $2959 $4177
20 $2653 $4247 $6728
25 $3386 $6098 $10,835
30 $4322 $8755 $17,449

All amounts rounded to the nearest dollar.

So let's say that you begin to save $200 every month when you are 23 and keep doing that faithfully for seven years. You average a return of 7% annually. As your income goes up, at age 30 you increase your savings to $300 monthly at the same 7% average return. Seven years later, at age 37 your family income allows you and your spouse to save $500 monthly. You continue to do this for 30 years until you retire at age 67. At an average return of 7% annually, your savings will exceed one million dollars. You'll have $1,158,719!

Next: 3. Retirement Planning by the Decade