Don't mess with Compounding!

On the back of continued (and at times staggering) rises in property prices across Sydney and Melbourne – numerous debates have raged regarding housing supply and affordability.

One measure flagged by the Treasurer earlier this year proposed that first home-buyers get early access to their Super to help them buy their first home.   In theory it’s a well-intentioned idea of assisting young people get a little piece of the great Australian dream.  Unfortunately like many well-intentioned ideas, in practice, they come with some not so pleasant unintended consequences.  I’d like to raise one of them.

It is generally accepted that Superannuation serves two main purposes; provide people with a respectable retirement income and reduce the burden on the tax payer of paying everyone a full pension.  On that basis we established a mandatory savings plan that begins when we enter the workforce and ceases when we retire from it.

Importantly, the fact you begin accumulating Super when you start work as a young person aligns with one of the most powerful drivers of wealth creation – compound interest.

Compound interest works like a snowball –  when the interest that accrues to an amount of money in turn accrues interest itself.   Just like a snowball gets bigger and bigger as it tumbles down the hill.

It occurs when you earn interest on both the money you’ve saved and the interest you earn.

So universally revered is the concept of compounding, it has been described as the royal road to riches and the most powerful force in the universe.  Even the great scientific mind of Albert Einstein was oft-quoted as saying compound interest is the eighth wonder of the world & man’s greatest invention. 

A fable that demonstrates this powerful force is the famous legend about the origin of chess. When the inventor of the game showed it to the emperor of India, the emperor was so impressed by the new game, that he said to the man, "Name your reward!".  The inventor responded, "Oh emperor, my wishes are simple. Give me one grain of rice for the first square of the chessboard, two grains for the next square, four for the next and so on for all 64 squares, with each square having double the number of grains as the square before."  The emperor agreed, amazed that the man had asked for such a small reward - or so he thought. After a week, his treasurer came back and informed him that the reward would add up to an astronomical sum, far greater than all the rice that could conceivably be produced in many, many centuries!

But there is a catch with compounding.  The catch is - compound interest needs time to work its magic.  The more time…the more magic!  Short-term sacrifice for long-term gain.

Former Prime Minister Paul Keating often seen as the architect of our Superannuation system – honed in on this point recently where he argued against allowing young people access to Super.  He reasoned that allowing young Australian’s to withdraw Super in their early years - will mean they forgo and diminish their savings ability to compound and therefore provide them a satisfactory income throughout retirement.

I’ve included below an example from a recent report from J P Morgan that demonstrates the power of compounding and impact of saving earlier and for longer;

  • Take for example Susan who saves $5,000 annually between the ages of 25 & 35 (in total she invests $50,000).
  • Then take Bill who saves $5,000 annually between the ages of 35 & 65 (in total he invests $150,000).

Assume they both receive a 7% annual return over the period - at age 65 they would have the following balances;

  • Susan would have $1,142,811
  • Bill would have $540,741

That is a staggering $620,070 difference even though Bill saved an additional $100,000.  Taking it a step further if we assume a running yield of 5% - it equates to an extra $31,000 of income per year in retirement.  Imagine the impact of having an extra $2,500 per month to spend on your lifestyle? 

The investment returns Susan earns in her 10 years of saving are snowballing to the point that Bill can’t catch up – even though he saves for an extra 20 years!!!

So although what seems an inconsequential act of allowing a 35 year old access to $50,000 of their Super  - it has a huge potential impact on retirement savings at age 65 and beyond.

It would be wise to take heed of Warren Buffett’s long-time business partner Charlie Munger who firmly says in reference to good money making habits – “don’t unnecessarily interrupt compounding”.  I can’t help but agree.