Retire Secure

Why it pays to start saving early

Saving is often very much at the back of any young, recently employed person’s mind. Unemployment among young people is high. In fact, that is an understatement – it is frighteningly high, with the official figure for young people at roughly just over 50%. Therefore, landing that first job is an achievement in itself! Rightfully it is a cause for celebration. But beware, do not throw caution to the wind. If you want to celebrate by showing off your new-found financial independence by indulging in elaborate purchases such as expensive clothes, phones, perfume or cologne and that very first car, you might want to think twice. Some short-term debt in the form of clothing accounts, credit cards or vehicle financing usually accompanies most of these purchases.

While some celebration is certainly warranted, now is the time you should start saving even more than at any other point in your life. Why, you might ask? Let’s look at a hypothetical example of two people who recently started their very first job.

Thando versus John

Thando, 25, recently started her first job and cannot wait for her first pay cheque; however, she recently read about the many South Africans who cannot afford to retire. So she decided to visit a financial adviser who advised her to start saving R1 000 per month in a tax-efficient investment such as a retirement annuity. While it represents quite a big chunk of her current salary, she is satisfied and feels empowered as she is taking control of her future financial independence. She continues saving R1 000 diligently for the next 10 years. But, due to unforeseen circumstances, she has to stop the monthly contribution. However, the investment continues to grow and generate returns.

John, who graduated with Thando, was also lucky enough to land his first job, right after graduation. He, however, enjoys the smell of new cars and has had four different, fairly expensive cars over the last 10 years and likes wearing expensive clothes. At age 35, and married, he decides to engage the services of a financial adviser, who subsequently advises him to seriously start saving for his retirement as he has not yet made any arrangements for his retirement. Due to his very expensive lifestyle, he can afford to save only R1 000 monthly and decides, based on the advice of his financial adviser, to also take out a retirement annuity. His decision to approach a financial adviser was a clever move and he continued saving his R1 000 over the next 25 years until he eventually retired at age 60.

The outcome

The above example is clearly hypothetical and saving R1 000 per month is not enough, but will suffice for the purposes of illustration.

Let’s assume that both Thando and John’s investment grew on average at 10% per year. Who do you think had the largest sum of money at age 60? You might be surprised to learn that it is in fact Thando, who contributed only R120 000 in total (R1 000 X 12 months X 10 years), who had the larger sum of money and not John, who contributed almost three times more: R300 000 (R1 000 X 12 months X 25 years). The graph below indicates how Thando’s investment (blue line) grew in comparison to John’s investment (orange line).

How is this possible?

The answer lies in compound interest. Albert Einstein apparently referred to this phenomenon as the eighth wonder of the world. Those who understand it, earn it (like Thando), and those who do not understand it, pay it.

The beauty of compound interest is that it works for you. For instance, if you invest R1 000 in year one and are able to realise a return of 10% in that year, after the first year your investment will be worth R1 100 (R1 000 plus the R100). During year two, you will not only earn a return on the original R1 000, but also on the R100 that you made during year one.

The longer the period of time compound interest has to work its magic, the better, so the sooner you start saving, the better. Therefore, the mere fact that Thando started saving so much earlier allowed her investment returns to start working for her and by year seven, the return she was receiving was already matching her contribution, i.e. R1 000. By the time she stopped contributing to her retirement annuity, her investment was delivering a return of R1 698.71 per month (exceeding the monthly contribution), and this is the reason why John could never catch up with her.

Therefore, at the age of 60 Thando had an amount of R2 478 228.93 saved, while John had only R1 338 890.35 saved.