By Linda Lacina
Most 401(k) participants fail to appreciate how much their savings appreciates over time, according to a new study. A lack of understanding of compound interest and sometimes faulty thinking could cause savers to enter retirement with higher debts, lower savings and lower net worth, the Journal of Marketing Research reports.
Researchers from the Rady School of Management at the University of California, San Diego and New York University’s Stern School of Business surveyed college students and employees at a Fortune 100 firm to gauge their knowledge of savings growth over time.
Researchers found nearly half the undergrads polled claimed they did not understand the concept of compound interest. The 53% who claimed they did understand, did not estimate savings growth accordingly. “That people’s intuition on compounding is terrible is no surprise,” says study co-author Craig McKenzie. “It’s how terrible it is that is a surprise.”
Additionally, most believed that savings increase linearly, at a fixed amount per period, and not exponentially, where growth increases as the current value increases. As a result, 84% of those tested in one experiment underestimated the savings growth of regular deposits at a range of interest rates. Many undergrads tested believed a $4,800 annual deposit with 10% interest over 40 years would grow to approximately $200,000, a mere 10 percent of the correct amount of more than $2 million.
Participants also misjudged the cost of waiting to save. Those surveyed believed it was easier to make up for lost time, forgetting the benefit of annual returns gained from decades of putting funds aside. Half of those surveyed thought someone with half as much time to save as someone else could catch up by doubling contributions. In reality, someone in that situation would need toincrease contributions by nearly eight times.
McKenzie, a Professor of Management and Strategy at the Rady School of Management University of California San Diego suggests consumers ask advisors for a graph or chart showing potential growth of a product (like CDs or IRAs) just before making savingsdecisions since the study shows visualizing savings has an immediate impact on motivation. He also advises consumers to test themselves on their current savings contributions, comparing what they think they’ll save over time with an amount found through online compounding calculators to help visualize savings.
Test your own savings predictions on the SEC’s compound interest calculator.
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