.

SmartMoney Blogs

Encore
A blog about living in and planning for retirement

Savers Need A Math Lesson

iStockphoto

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.

See how ready you are retirement, with SmartMoney’s Retirement Calculator.

Comments

We welcome thoughtful comments from readers. Please comply with our guidelines. Our blogs do not require the use of your real name.

Comments (5 of 9)

View all Comments »
    • They have a poor grasp of it because none of them see it in action. Interest rates on common savings vehicles are dismal, and have been for more than a decade. The rates at my bank, even for low end CDs, are at or below 0.25%. At that rate, with “normal” sized savings accounts, you have more to gain by forgoing ONE latte each MONTH than you get from compounding interest.

      Compound interest only helps people who have a lot of money sitting around, or people who can afford to make the investments that give out high interest payments. Good for them, but compound interest is line noise to most of us. Find me an affordable investment that will get me 10% and then we’ll talk.

    • Just tell me where my investments can get 10% interest, then? Should I start a credit card company?

    • Your numbers tell a different story than your comment. Using those numbers, if you save $110 per week for 40 years and earn 4%, you’ll end up with $562K — a tidy sum.

      But if you save $55 per week for 40 years and earn 7%, you’ll end up with $625K — even a tidier sum.

      No one argues that you have to save to make any of this work, but the math suggests that the rate of return you earn may be more important than the amount that you save.

    • The article suggests that you save about $100/ week for 40 years. $100 for 52 weeks is $5200. (If you want 10% on your money, make it $110.) This is the most important step. Take this money out of your pay before you ever see it. Next go buy a calculator that will figure Future Value — N (button), I/Y (button), PV (button), PMT (button), FV (button) and learn how to use it. I’ve had mine — a TI BA II PLUS for many years. $110 times 52 weeks is $5720/year (I’ll increase my wealth by a 10% gain immediately!)
      $5720 times 40 years is $228800. Now, that’s with no interest gain. 1% — $280,788. 2% — $349,591. 3% — $440804. 4% — $562613. 5% — %726385. 6% — $947949. 7% — $1,249,411. You deceide what kind of risk you want to take. May the wind be at you back & good luck!

About Encore

  • Encore examines the changing nature of retirement, from new rules and guidelines for financial security to the shifting identities and priorities of today’s retirees. The blog also explores news that affects retirement, from the Wall Street Journal Digital Network and around the web. Lead bloggers are reporter Catey Hill and senior editor Jeremy Olshan. Other contributors include The Wall Street Journal’s retirement columnists Glenn Ruffenach and Anne Tergesen; the Director for the Center for Retirement Research at Boston College, Alicia Munnell; and the Director of Research for Pinnacle Advisory Group, Michael Kitces, CFP.

.