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Albert Einstein allegedly remarked on his deathbed that while he was unsure of the Seven Wonders of the World, he was certain compound interest ranked as number eight! Regardless of your age or genius quotient, understanding the “wonder” behind compound interest is important when making financial decisions.
For people approaching Social Security age, the wonder of compounding interest comes from the annual cost of living increase (keep in mind there have been two years including 2016 when there was no cost of living adjustment). Recently, a gentleman visited our office and said it clearly made sense for him to claim his Social Security early and invest the income. While this could be the right strategy for some individuals, it was clearly a mistake for him.
A look at the numbers explains why claiming Social Security based upon age eligibility can be costly. First, consider the 8% reduction in Social Security benefits for each year you claim early. Individuals who claim at 62 lose almost a quarter of their income for life. But it gets even worse. When the cost of living adjustment is factored in, you also lose compounded interest on that number.
For example, if a person’s full retirement age benefit is $2,000 and he takes the benefit at age 62, he can expect to receive a monthly benefit of $1,557. If the cost of living adjustment averages 2.5% over a 20-year period, and his neighbor waits until full retirement age to claim Social Security, the neighbor can expect to receive a monthly income of $3,277 a month. The person who claimed at age 62, could expect monthly income of $2,747 23 years later. The original $443 a month deficit between the early claimer and his full retirement age neighbor would have grown to $530 monthly due to the wonder of compound interest. And the spread will increase as they age.
Ultimately, several factors prompted our visitor to delay claiming Social Security, but this article is focused on compound interest how its value is often overlooked in our decision making process. Now let’s turn the math to explore why saving as early as possible matters for younger individuals.
Imagine that you have $1 dollar to invest just once and that this investment will average a 7% return. If you have 10 years to wait, that single dollar grows to $1.96. In 20 years it will grow to $3.87 which becomes a game changer. For those of us who have 30 years to save, the dollar grows to $7.61 and for my lovely daughters with 40 years to save, each and every dollar will grow to $14.97! Compounding interest truly is the eighth wonder of the world.
The uncertainty of the 2016 elections, the value of the dollar, the arguable over-valuation of the equity markets, and myriad other factors cast uncertainty on market returns this year. None of these considerations have anything to do with the 10 year horizon. Start saving today and use a Roth IRA when you can!
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer[/vc_column_text][/vc_column][/vc_row][vc_row][vc_column offset=”vc_hidden-lg vc_hidden-md vc_hidden-sm”][vc_widget_sidebar sidebar_id=”sidebar-main”][/vc_column][/vc_row]