Planning for retirement is one of the most important tasks we take on in our lifetimes. What are the fundamental principles of retirement planning?
It's never too early to start planning for retirement. The sooner, the better.
The lesson that can be derived from this example is that the sooner you invest for retirement, the better. (Unless, for instance, John invested $2,000 into the stock market, it then collapsed, and John ended up with less than $2,000 after 10 years. This is why it is necessary to diversify your investments.)
Now, let’s say that, in addition to initial $2,000 investment, John and Mary invested $500 each year. John for 45 years, and Mary for 35 years. Both earned 9% a year.
At the age of 65, John would have $359,584. That’s $262,929 more than John would have if he didn’t invest that extra $22,500 every year.
Meanwhile, Mary would end up with $148,683, which is $107,855 more than if she didn’t invest that extra $17,500.
So, investing early is important, but contributing over the years, even a small amount, adds to a huge difference.
Now, let’s assume that John and Mary earned 1% more, or 10% return. John would have $505,233, and that is $145,649 extra for earning just a measly 1% more! Mary would do much better too with her $191,717, which would leave her $43,034 wealthier for earning that extra 1% over many years.
Here’s another important concept: Even small extra return can account for large sum of money if compounded over many years. Keep that in mind when paying fees to financial advisors. Smaller fees make a big difference.
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In most developed countries, there are two kinds of pensions. One is state pension which requires working for a certain number of years before qualifying, while its payout depends on the number of years worked, salary, and the age at which retirement is taken.
The other kind is a private pension. It consists of funds accumulated in addition to state pension, and is independent of the state pension. Effectively, it is possible, and advisable, to derive retirement benefits from more than one source. Both public and private.
The great power of compounding
Contributing to personal retirement accounts (private pensions) as early as possible is advisable in order to take advantage of compounding. Let us give you an example. We have John who made a one-time contribution to his private retirement account at the age of 20. Mary, on the other hand, made the same one-time contribution at the age of 30. Both will retire at 65. In this example, let’s assume that they will earn 9% return on their investments.
We expect John to have more money than Mary when he retires since he had more time for his investment to grow. After 45 years, John will have $96,655, while Mary, after 35 years of compounding, will have $40,828. It’s a big difference. More than twice as big.