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The Amazing Power Of Compound Interest

If you were to ask a 25-year-old where their superannuation is invested, at least half of them would have no clue. They probably would not be able to tell you what fund it is in. If they do know the actual fund, try asking them about the portfolio they have within their fund. It is likely by now that you will find at least three-quarters of 25-year-olds have little to no engagement with their superannuation whatsoever. It is understandable though as it is money that they are not able to touch until they are 60 and are likely to be 65 or older by the time that they retire. Why worry about it now?

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The amazing power of compound interest
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Written by

BERIVAN DUBIER
Last Updated Jun 16, 2021
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The Amazing Power Of Compound Interest

It is because now is the most important time for them to worry about their super – and the reason behind that is because of the impact of compound interest.

Take as an example Melissa, a 25-year-old that has $20,000 in her superannuation. The default product that she is invested in is the balanced product, but she also has options to choose more conservative or more aggressive portfolios. The money will still be in her super fund for another 40 years. How important is a small increase in the rate of return to what she already has in her super?

$20,000 invested for 40 years at a rate of return of 5% will equal $140,899.80 in 40 years. At an inflation rate of 2% that is the equivalent of $63,767 in today’s money. It is still a good result, but how could it be made better? Investing $20,000 for 40 years at 7% would net $299,489 or $135,636 in today’s money. That is almost double the money that had been initially invested.

Now is a crucial time for everyone, young and old, to consider their superannuation portfolio to ensure that they are always receiving the best return possible. It will be far too late to do so when they hit retirement age after all.

Helpful tip:

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Starting to save or invest early allows compound interest more time to grow your wealth. Make regular contributions whenever possible, even if the amounts are small. Staying invested over the long term can have a significant impact on your financial future.

BERIVAN DUBIER

DIRECTOR

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SEAN DWYER

DIRECTOR
CPA and financial adviser for over 25 years. Loves to help businesses grow. Dad, jogger, cyclist, windsurfer and bad skier.

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FAQ

What is compound interest?

Compound interest means earning interest on both your original amount and interest already added to it. In superannuation, the similar idea is that investment returns can remain invested and contribute to future returns. Actual super returns vary from year to year and may be negative, so growth is not as smooth as a fixed-rate illustration.

How does a small difference in returns affect a long-term balance?
For illustration, $20,000 growing at a constant 5% a year for 40 years would become about $140,800, while 7% would produce about $299,500. That assumes annual compounding and no further contributions, fees, tax or withdrawals. Neither return is guaranteed; the example shows why differences in net returns can matter substantially over long periods.
Why does starting early make such a difference?

An earlier contribution has more years in which returns can build on previous returns. In the same simplified example, $20,000 at 5% for 30 years becomes about $86,400, compared with about $140,800 over 40 years. The extra decade does much more than add ten times one year’s return because the growing balance continues to earn returns.

Do regular contributions help compounding?

They can. Each new contribution adds to the amount invested, and earlier contributions have longer to grow. Employer contributions and any voluntary amounts can therefore affect the eventual balance alongside investment performance. Before contributing extra, consider contribution caps, tax treatment, access restrictions and whether you need the money outside super.

Should I choose the highest-growth super option to maximise compounding?

Not automatically. Growth options generally hold more shares and other growth assets, so their value can fluctuate more and they may lose money over shorter periods. Compare the option’s mix of investments, risk, fees and long-term performance with your time horizon and tolerance for losses. A higher assumed return in an example is not a promise of a better outcome.

How do fees, tax and inflation change the result?
Fees, insurance premiums and tax reduce the balance available to invest, and inflation reduces what a future dollar can buy. A projection using a fixed gross return can therefore overstate the amount you will have to spend in retirement. Compare investment options on a consistent after-fee basis and use a super calculator that allows for contributions, fees and inflation.
What should I review in my current super account?
Check which fund and investment option you hold, your asset mix, fees, insurance cover, contributions and long-term performance against comparable options. Look at the fund’s product information and statements before changing anything. If you have multiple accounts, consider the fees and any insurance you could lose before consolidating them.
Can compounding work against me?
Yes. Interest added to an unpaid loan or credit card balance can itself attract further interest, causing debt to grow. Regular repayments and the interest rate determine how quickly the balance falls. The same compounding principle makes time valuable when saving, but costly when expensive debt is left outstanding.

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