It pays to save early and aggressively
In today’s economic environment, to retire comfortably at 60 you would want to have savings equal to about eight to 10 times your annual salary immediately before retirement.
To retire comfortably at 60 you would want to have savings equal to about 8 to 10 times your annual salary immediately before retirement. FILE PHOTO | NMG
We all constantly hear about the need to save: Save for a rainy day, save for your children’s education, save for your retirement and so forth. However, in today’s world of consumerism and instant gratification, it is easy to get tied up in the here and now and to believe that the future will work itself out. As soon as that time machine is up and running, Future You will be coming to give Present You a piece of their mind!For those of us that do save regularly, it can be challenging to know how much to save, or where to invest our savings. Too often our primary focus is on the fees we pay for investment services, when we should really be focusing on the value we get for the fees we pay. For example, if investment manager A consistently delivers one per cent more in returns each year than manager B (net of fees and expenses), then what does it matter how much more expensive manager A is? You are getting more in returns and they are worth every penny.
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The power of one per cent stems from the ‘magic’ of compound interest. Compound interest, in simple terms, is where your interest earns interest. In other words, after the first year your savings will have grown with interest. In the second year, the first year’s interest is part of your savings and hence will also earn interest in the second year – hey Presto! Compound interest.To show you the impact of compound interest, let’s use a simple numerical example. Let’s assume you save a fixed amount of Sh1,000 every month for 30 years. The table above shows your savings balance after 30 years, applying different net investment returns.The table should illustrate the power of one per cent. Another point to note from the table above is just how much of your balance is made up of interest. Remember, in all three examples above, your own capital is only Sh360,000 (Sh1,000 x 30 x 12). That means that over 80 per cent of your balance is actually investment income and not your contributions!Equipped with a better understanding of compound interest and the power of one per cent, let’s try and illustrate the importance of saving early and maximising your returns in the form of an example.Let’s take a new graduate, Patricia, who is starting out her career at the age of 20 years. Patricia would like to secure her financial well-being and decides to immediately start saving 10 per cent of her salary every month. If we assume that Patricia’s salary goes up eight per cent every year, and that her savings earns net interest of 10 per cent every year, when she reaches the ripe age of 60 years, her savings account will be 6.1 times her annual salary at that time.What if Patricia had procrastinated on her savings plan and not actually started saving until she was 30? Now she is saving for 30 years instead of 40 years, but that is still a long time to save and she should still build up a large savings balance, right? Wrong! Instead of having a balance equal to 6.1 times her annual salary, her balance will only be 4.2 times her salary.READ: Most Kenyan workers invest in real estate and land for retirementShe would have to save nearly 15 per cent every month, instead of the originally planned 10 per cent simply because she started saving later to reach the same goal. Let’s go back to the pro-active Patricia who saved for 40 years, and let’s see the power of one per cent. Remember, Patricia has saved up a balance that is equal to 6.1 times her final salary, by saving 10 per cent of her monthly salary (and assuming she earns 10 per cent a year on her savings while her salary grows eight per cent each year). If Patricia can earn an extra one per cent return on her investments (a return of 11 per cent per year), her savings balance at 60 years will be 7.6 times her annual salary, instead of 6.1 times her salary. Her savings balance is 25 per cent larger, simply because she earned one per cent more each year!When you start saving early, and you save aggressively, a little can go a long way. In today’s economic environment, to retire comfortably at 60 you would want to have savings equal to about eight to 10 times your annual salary immediately before retirement. This should allow you to secure a lifetime pension that replaces at least 70 per cent of your pre-retirement income and allow for some modest annual increments to help protect you against inflation. In 40 years time, you will probably need even more to replace that level of pre-retirement income – even more reason for you to save early and aggressively!