Compounding returns are a key principle in wealth creation, and understanding how it works is the first step toward reaching your retirement goals.
So what exactly are compounding returns and how can they help you?
Put simply, compounding returns are when you earn investment returns on your previous investment returns.
It works like this:
Let’s say you start with an initial investment of $10,000, make no withdrawals (i.e. your returns are reinvested) and you earn 10% p.a. every year after fees and tax. After your first year you’d have $11,000 (your initial $10,000 + 10% returns = $11,000).
By the end of year two, your investment would be $12,100 ($11,000 + 10% = $12,100). Note that compared to the previous year, your returns have increased by an extra $100 ($1,000 of returns in year 1 vs. $1,100 of returns in year 2). That’s because you earned 10% on both your original balance and the returns from year 1.
That extra $100 might not seem like much. However, using this example, after 20 years your initial $10,000 investment would have grown to $67,275 and the returns earned in year 20 would have risen to $6,116 versus just $1,000 in year 1. That’s the power of compounding.
Believe it or not, because of compounding, your investment returns could make up the bulk of your KiwiSaver savings at retirement.
Below is a hypothetical KiwiSaver investor’s account at age 65.
We’ve assumed the investor is 35 years old today; earns $75,000 annual gross salary, has a $0 starting balance, employer and employee contributions of 3%, wage growth of 2.5% p.a., makes no withdrawals and their investment is earning a net return of 8% p.a.
In the above example the investor’s returns compounded to make up about 70% of the total value of the account. Meaning all the investor’s contributions combined only equalled about 30% of the account.
This illustrates how important investment returns are to achieving your retirement savings goals.
The rate of return your KiwiSaver fund achieves (after fees and tax) is critical because your returns are compounding year after year, eventually becoming the primary driver of how much your account can grow. In other words, the performance of your fund will directly affect whether or not you are able to reach your retirement savings goals.
If you’re curious to estimate how your own KiwiSaver account could look at age 65, you can try our free KiwiSaver Retirement Planner found here.
Disclaimer: This is intended to provide general information only. It does not take into account your investment needs or personal circumstances and so is not intended to be viewed as investment or financial advice. Should you require financial advice you should always speak to an Authorised Financial Adviser.