TSP Talk – The Magic of Compound Interest

Good morning. I have written my usual daily market commentary on TSPtalk.com, which I have been posting here on GovLoop.com on Mondays – but while I was re-reading it, I realized that it may not be the best article for anyone who may be new to trying to grasp the task of managing their own TSP account. I decided instead to write a separate article to talk about some basics on investing. I’ll try not to get too boring.

The most important ingredient to a good investment plan is time. It is rumored that Albert Einstein once said that, compound interest is one of the most powerful forces in the universe. So, for anyone new to the retirement savings world, the best advice I, or anyone else can give you, is to start now, and put away as much as you can afford, and that’s usually more than you think. Come on… How many lattes have you had this month?

Your initial goal should be to put at least 5% of your salary into the TSP because your government agency will match up to that amount. Hey, that means you get an instant 100% return on your money. Take it!

So, if you are making $20,000 a year, for example, that means you are saving $2,000 a year. I can’t verify the accuracy of all the figures in the table below, but assuming it is accurate, you can easily see the power of putting your money to work for you early.

Source investingforstudents.org

Once you have your savings plan in place with automatic deposits into your TSP, time and rate of return take over. For arguments sake, we’ll use an expected rate of return of 8% and 12%, since the stock market has averaged somewhere in the neighborhood of 10.8% per year for the past 75 years.

To get that, you do need to take on some risk which means using the stocks and bond fund. The younger you are, the more risk you should be willing to take on. As you move closer to retirement age, you will want to reduce risk. Why? You can see what the current stock market environment has done to account values. If you had your money 100% in the C-fund in 2008, as of 11/21/08, you would be down over 44%. That’s difficult to recover from in 4 or 5 years, but if you had 20 or 40 years, it is just a blip on the radar screen…

Why not just take the safe route of the G-fund and get your guaranteed 3% to 5% (depending on the going rate)? For one reason, a 3% to 5% return is barely keeping up with inflation. If you are only keeping up with inflation, your real return is basically 0%. Your account is not appreciating but rather maintaining its deposited value.

It may be a little difficult to view, but here are a couple of things to notice from the chart above:

Let’s look at the 8% column. Assuming the 10% $2,000 annual deposit (5% from you, 5% matching), after the first year your account will have made $160 ($2,160 – $2,000). Not great, but wait. It gets better. After 10 years, you will have made $9,293 ($29.293 – $2000×10). How did you go from making $160 a year, to averaging $929 a year ($9,293 divided by 10)? Compound interest. You not only make 8% on the $2000 per year you deposit each year. You are also getting 8% on the money you are earning.

In another 10 years, that $29,293 becomes $92,214, even though you only deposited another $20,000 ($2,000×10). After 40 years your total deposit of $80,000 ($2,000×40) becomes $521,331. At that point, an 8% return would make you $41,706 the next year.

If you surprise yourself and discover that you have become somewhat of a market timing wizard and can manage to make a 12% annual return, your $80,000 would have become $1,554,122 in those same 40 years, and that would make over $124,000 the following year.

This is all assuming you do not increase your 5% annual deposit, and obviously most adults will see an appreciation in their annual salaries, so you will be contributing more to your accounts each year, and hopefully increasing your percentage from 5% up toward 10% or 15% (still receiving the 5% matching amount from your agency).

So, the keys are to start early and get your money churning in your account, and to maximize your return by taking on some risk when appropriate.

At TSP Talk, we talk more about how to maximize our returns and protect our capital, depending on the current economic and market environments. It is not an easy task, but we would rather be in control of our money than be at the mercy of a volatile market.

Thanks for reading. We’ll see you next week.

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Thanks for the post Tom. Let’s hope we get at least one convert. The magic of compound interest is amazing. I love the tables – it really shows it in your face.