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It's advice you've probably heard more than once, especially when you were young, "Start saving as soon as possible for retirement." Many ignore the admonition, while others heed the sage advice and end up much better off in the long run. But what's behind the concept of "saving early"?
Is there some magical reason that a head-start is such a great idea? To take the other side of the argument, why not wait until sometime after the age of 30 or 40, when you are likely better able to support a substantial monthly savings amount?
The short answer: Because savings accrue interest with each passing year, the "time value of money" is on the side of early savers. In fact, the power of being an early-bird retirement saver is even greater than most folks think. Here's why:
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Compound Interest is Strong Medicine
The core concept behind the whole strategy of long-term saving and getting started as soon as possible is compound interest. When a savings account accrues interest after the first period, whether a month or year, the new balance serves as a fresh starting point. The next period's interest accrues on the already-earned interest payment from the prior period.
The cycle goes on until the account is closed. Mathematically, the act of "paying interest on interest" allows for potentially massive growth of the original amount if the account is open for many years. That power is multiplied if the saver continues to add money on a regular basis.
You Can't, and Shouldn't, Rely on Social Security
Regardless of what people believe, there is no guarantee that the Social Security system will remain solvent for the long term. This fact is of particular importance for younger workers in their twenties and thirties, who won't be retiring for at least several decades.
For older folks who are nearing retirement, the social program's payouts are more assured, but it is not wise to rely on them as a primary means of support.
In fact, when the Social Security Administration was first created, the income was intended to be "supplemental" and not the main means of covering one's monthly expenses.
Starting Young Means You Can Make Smaller Monthly Contributions
For those who make the smart decision to begin saving in their late teens or early twenties, there's a subtle advantage that is often overlooked: A head start means you have the ability to make smaller monthly additions to your account throughout your entire career, right up until the day you retire.
Note that a few years can make a major difference in the amount people regularly need to add to their accounts to hit a specific savings goal by age 65 or whenever.
You Could Live a Lot Longer Than You Expect
Living a long, healthy life is a good thing. Make no mistake about that fact. But there's a potential downside to longevity if your savings goals are limited. What happens if you reach a savings target but end up living until the ripe old age of 90, 100, or longer?
For working folks in their twenties, that's not out of the realm of possibility. If you want to plan wisely and conservatively, consider adding a decade to whatever your current life expectancy estimate is.
Circumstances Could Force You Into Early Retirement
As noted above, there's a realistic possibility of living a very long life, which has a direct impact on savings strategies. That's just one reason it makes sense to save more, save earlier, and stick to the plan from now until retirement. However, what if illness or other circumstances force you to retire early?
Every year, millions of adults must stop working due to poor health, an unexpected disability, the need to stay home and take care of an ailing spouse, or an economic slowdown in their chosen career field. Those kinds of events might curtail your ability to contribute to a savings plan. What's the solution? Start now, and set aside as much as you can afford.
A Realistic Example of Four Scenarios
Here's a realistic but hypothetical example that explains why it's necessary to save "early and often."
Suppose four people save in different ways. Three, Janet, Moto, and Keesha, are able to find an investment account that pays 6.25% interest, while the fourth, Hillary, decides to put her money in a savings account that pays 2%. Each saver places $100 per month into their respective accounts, but they don't all begin and end at the same time.
What's the final tally for these four approaches? Here's the outcome.
Note that the person who used the power of compound interest for the full 40-year time span, Moto, built up the healthiest total.
Janet and Keesha ended up with about the same amount even though Janet only saved for 10 years compared to Keesha's 30 years. How did that happen? The sole reason is that Janet saved early and allowed the amount to continue earning interest even when she was not making additional contributions.
Hillary, who did start early and stuck with it for the entire 40-year period, came out on the bottom because her interest rate, 2%, was significantly lower than the other savers' rate of 6.25%.
What's the Lesson of the Example?
There are actually three factors for winning the retirement game. The most important is to begin as early as possible in order to use the power of compound interest in your favor.
The second is to save consistently until your retirement year arrives. Finally, aim to secure a solid interest rate by shopping around for the best instruments and institutions.