How Compound Interest Can Destroy Your Retirement

Written by Julie Brownlee on June 29th, 2016

How Compound Interest Can Destroy Your Retirement

When it comes to financial matters, there’s nothing more important than your retirement.

There are many investment vehicles to assist you to save towards the retirement you desire.

Regardless of the route you take, there is one common factor: Fees.

On the face of it, a couple percent in fees may not seem that important, but the truth is fees eat into your investments and, over the years, the impact is immense.

So what impact do fees actually have?

What type of fees do you need to watch out for?

And can you get the best deal?

Let’s take a closer look…

 

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The Key To A Brimming Retirement Pot

 

Preparing for retirement is daunting.

It’s no secret that the earlier you start contributing towards retirement, the better.

This is because the longer you have your money working for you, the more compounding can work its magic.

What Is Compounding?

Compounding is when an asset generates earnings (or interest), which generate their own earnings over time.

In other words, your returns earn returns and this snowballs the potential growth of your investment.

To illustrate the power of compounding in its simplest form, let’s imagine that you invest R100,000 at a fixed interest rate of 10% a year. There are no fees.

At the end of year one, your R100,000 investment has grown to R110,000.

Jump to the end of year five and your investment pot has grown to R161,051.

By the end of year ten, the value of your investment has soared to R259,374.

And by the end of year 20, you have an astounding R672,750. That’s an additional R572,750 from your initial investment of R100,000.

If you’d withdrawn your annual return each year, over 20 years, you would have only made R200,000.

That’s R372,750 less than if you’d let compounding do its thing.

Here’s the impact of compounding on your investment over 20 years in chart form…

The Power of Compounding

As you can see, as time passes, the slope steepens. This reflects the effect of compounding growing your money more quickly.

How To Speed Up Compounding

To make the most out of compounding, contributing regularly to your investment speeds up the process.

This is why contributing to your retirement savings and investments is so vital.

If you weren’t convinced about the importance of starting to save early for retirement, understanding compounding makes it clear to see why.

 

 

So What Difference Do Fees Make?

 

Compounding is key to growing your investment over the long-term.

The problem facing compounding is fees.

Annual fees eat into the earning potential of your retirement pot. And the unfortunate thing is fees don’t have to be high to cut a chunk off your investment.

To illustrate this, let’s look at the impact of varying levels of fees.

We’ll base this example on an initial investment of R100,000 with an annual rate of return of 10%.

The variable is the fee payable:

  • 0% fee;
  • 0.5% fee;
  • 1% fee;
  • 2% fee; and
  • 3% fee.

These fees may not look high on the face of it, but even the smallest fee of 0.5% eats into a significant chunk of your investment.

The following chart shows you the impact of these fees over the course of 40 years…

The Impact of Fees Over The Long Term

It’s clear to see the major effect that fees have on your investment.

And, most importantly, the longer you invest, the higher the impact of fees.

Let’s have a look at this in more detail.

The following table shows you how much your investment is worth over the years depending on the fee charged…

Investment Fee Breakdown

As you can see even a small fee makes a heavy impact.

If you invested your R100,000 in a fund charging 0.5%, you’d be R2.4 million better well off than if you’d invested in a fund charging 3%.

As investing for retirement is for the long-term, it’s clear to see why what you pay in fees can determine your future riches.

 

And That’s Not The Full Story…

 

Our example only looks at the implications of an annual fee, but there are also other fees and charges you need to watch out for.

For example…

Financial Advice

If you use the services of a financial advisor or financial planner, you’ll have to pay for them.

You may find you pay an initial fee then a monthly ongoing fee.

Work out how much this advice is going to cost you over the long-term.

You may be better off paying for advice only when you need it.

Administration Fees

These may be one-off or set periodic fees for investments.

Ideally you want to find retirement investments that exclude this type of cost.

Management Fees And Commission

If you opt for an actively managed fund, for example, you’re going to pay for it.

Whilst the idea of a fund that outperforms the market over time may appeal, the impact of fees on your investment mean that passively managed portfolios will cost you much less over time.

Over the long-term, fund managers find it extremely difficult to outperform the market. This also makes market trackers much more appealing.

 

What You Need To Do About Your Retirement Investments

 

One of the most important factors when selecting investments for retirement is fees.

The more you pay in fees, the poorer you’ll be in the future.

When you’re looking for suitable retirement investment vehicles, you must ensure you find the best solution for you with the lowest fees.

Over the past few years, new entrants to the market are offering much more competitive fees.

Not only that, don’t be scared to try to negotiate for lower fees.

With competition rife, it’s time to turn this to your advantage.

It’s worth taking time to trawl through the different investment houses to find the best home for your retirement savings.

I know that I’d rather invest my time in seeking out an investment with fees of 0.5% rather than opt for fees of 2% and watch my retirement savings erode over time.

Until then, here’s to a profitable retirement. 

Julie Brownlee | The Money Lab

Julie Brownlee
Editorial Contributor
The Money Lab