What’s harder than getting your clients who are reluctant to save to have the discipline to regularly contribute to their investment portfolio? Try explaining the benefits of compounding and the potential benefits of delayed gratification to this same group of low savers.
It seems that many of my five children enjoy drinking coffee. Not just any old cup of joe, mind you, but a premium cup of java from one of those famous coffee chains. Just hearing them place their orders sounds as if they’re speaking in a foreign language. These cups of fancy coffee can cost upward of $5 or more. Meanwhile, I calculate my standard cup of home-brewed coffee costs about 10 cents.
How much is that special brew really worth?
Sometimes when we’re making the drive to the coffee shop, I’ll try to get them to think about the possibilities were they to save their money and buy a lower-priced version or—heaven forbid—try a cup of their dad’s home brew. As you can see in the graphic below, that special cup of coffee really adds up over time.
Compounding: One cup of coffee at a time
* Source: Ashley Rodriguez, 2016. The average cost of coffee in your city. Accessed May 1, 2017, at http://www.baristamagazine.com/average-cost-coffee/.
** Invested in a low-cost, diversified Roth IRA. The final account balance does not reflect any taxes or penalties that may be due upon distribution. Withdrawals from a Roth IRA are tax-free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both.
This hypothetical illustration does not represent the return on any particular investment and the rate is not guaranteed.
By pocketing the $3.50 for coffee each day and investing it instead in a low-cost, diversified Roth IRA, you’d have an estimated $106,000 after 30 years. I don’t think anyone would pay $106,000 for coffee! I know Warren Buffett certainly wouldn’t.
As a young man, Buffett wondered if he really wanted to spend $300,000 for a haircut.1 By getting his locks trimmed every five weeks instead of four, and spending $18 instead of $25, Buffett estimated he’d save an estimated $300,000 over his lifetime.
A few bucks here, a few bucks there … can pay big over the long term
The bottom line is, small changes in financial behavior can have big consequences over time. Getting clients to increase their annual retirement savings contributions by as little as 1 percentage point can have a huge impact.
It’s smart decisions like these that can make the difference down the road, so clients can buy that sports car, take that trip to Europe they’ve long dreamed about, or even retire a few years earlier than they had planned. And it’s not just about investing a little more early on. It’s also about counseling your clients not to wait until the last minute during the course of a year to invest.
Procrastinating can be costly
A few years ago we looked into quantifying how high the procrastination penalty could be for an investor. The research looked at investors who waited until the tax deadline to make their IRA contribution for the previous year.2 The result? Simply by waiting 15 months to make their annual contribution, clients could potentially lose $15,500 over 30 years.
“Procrastination penalty” over time ($165,000 contribution over 30 years):
Notes: This hypothetical example does not represent any particular investment and the rate is not guaranteed and is provided for the purposes of illustration only. All figures are in today’s dollars. “Early bird” contributes January 1 of the tax year; “Last minute” contributes April 1 of the following year. Figure assumes each investor contributes $5,500 for 30 years and earns 4% annually after inflation. Projected balances are as of April of the ending year, when the procrastinating investor makes the final contribution. The final account balance does not reflect any taxes or penalties that may be due upon distribution. Withdrawals from a traditional IRA before age 59½ are subject to a 10% federal penalty tax unless an exception applies.
“Compound interest is the eighth wonder of the world”
Albert Einstein said, “He who understands it, earns it … he who doesn’t … pays it.” The phenomenon of exponential growth as your returns build upon themselves over time is something deeply comforting to long-term investors.
Study after study has found that Americans aren’t saving enough for retirement. The median account balance among Vanguard retirement plan participants in 2015 was $26,405, which was down 11% from 2014.3 At Vanguard, we recommend retirees save enough to be able to spend at a rate of 75% of their annual income while they were working.
The best way to change that trend is to continue to encourage your clients to look at their spending through a compounding lens and to calculate how much their regular purchases would equate to over time. Time is the biggest advantage young investors have. As you well know, getting clients to focus on saving for something that’s decades away can be difficult.
Giving your clients simple, real-life examples may be just what they need to persuade them to make small changes now. I’ll take my home-brewed coffee over that $106,000 coffee any day.
1 Alice Schroeder, 2008. The Snowball: Warren Buffett and the Business of Life. New York: Bantam Books.
2 Stephen Weber and Maria Bruno, 2014. Are investors subjecting themselves to the “procrastination penalty”? Valley Forge, Pa.: The Vanguard Group.
3 Vanguard, 2016. How America Saves 2016. Valley Forge, Pa.: The Vanguard Group.