Canny View: The power of compounding

Nick Stewart

I hear young people complaining on a regular basis that it's impossible for them to save money. The list holding them back is a long one – student loans, minimum pay, rent, coffee, and the desire to enjoy their youth.

I get it.

It can be hard to find the money and saving for your future isn't high on the list of priorities when you are young and feel invincible.

My typical solution to this group is twofold: Start small and automate it.

Starting small helps for a couple of reasons. There's a sense of loss in some ways when you start saving because delayed gratification means less fun money today. And even small amounts can really add up over time because the biggest asset you have as a young person is your human capital and the long runway ahead of you to allow compounding to do the heavy lifting.

The reason you automate is that you'll never save what's left over at the end of each pay period. Paying yourself last does not work very well because something will always come up and if you don't automate your savings there is a high chance that you will either eventually give up or forget to save in the first place.

Let's see these ideas in action using some realistic and unrealistic assumptions.

First, let's start small by assuming a young person can start out saving $25 per month. That's our realistic assumption.

The unrealistic assumption is that you earn 6% return per year on that money starting from age 20 until 65. No one earns consistent returns like that but making this assumption helps show the power of compound interest.

If you were to continue saving $25 per month from age 22 to age 65 you would end up with a little more than $60k. Not exactly enough money to retire on.

But what if instead of saving $25 each month for the entire period, you slowly but surely increased the amount you save every year. What if you saved just $5 more per month every year? Or even $10 or $25 or even $50 more per month every single year to work your way into a higher savings rate?

Now things look much better. Adding $5, $10, $25, and $50 every month to your savings each year is an annual increase of just $60, $120, $300, and $600, respectively. These aren't enormous sums of money but look at the massive differences in the ending balances. A combination of 6% return per year and the power of compound interest, you could add up to 215k, 371k, 838k and 1.6m respectively.

Saving $25 a month over the course of a year is only $300 in total but adding $50 per month to that total every year using an incremental approach can add up to a fairly large sum of money through a combination of diligent saving and compound interest.

For most of us, KiwiSaver is the main voluntary private savings vehicle to help you with your long-term saving for retirement and it fits well with the philosophy 'start small and automate it'. With KiwiSaver, you can start small (3 per cent from your pay) and the best part – it is automated.

If you are already a KiwiSaver member and currently contributing the 3 per cent minimum employee contribution from your salary, determine the impact of increasing your contribution rate to 4 per cent or 8 per cent. Increasing your contributions is one of the most effective ways to enhance your future savings. Also, check whether the fund you're invested in is appropriate for your needs and tolerance to risk.

Any returns earned by your KiwiSaver account are added back into your account to earn further returns in the future. This is when interest earns even more interest, like a snowball grows as it rolls downhill. The earlier you start saving the bigger your investment can grow. Decades of paying into an investment like KiwiSaver can build a pretty impressive snowball.

As James Clear pointed in his book Atomic Habits, massive success does not require massive action, but minor improvements that can compound on top of one another.

Every little bit helps when you're young and have decades and decades ahead of you. Building wealth from a young age doesn't require a ton of money if you remain disciplined and work your way up to a healthy savings rate.

*Nick Stewart is the CEO and Authorised Financial Adviser at Stewart Financial Group, a Hawke's Bay-based independent financial planning and wealth management firm based in Hastings. At Stewart Group, we believe the quality of the advice is as relevant as the choice of your KiwiSaver provider, and we encourage our clients to seek tailored advice on contribution rates and fund choice to track their progress towards retirement.

*The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed or relied on as a recommendation to invest in a financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any financial decisions. A disclosure statement can be obtained free of charge by calling 0800 878 961.