Posted By Mimenta on April 25, 2017
Note – when we say retirement, we don’t mean at 65 years old. It could be any age at all, it’s simply a matter of planning and putting enough into that plan to make it happen when you want.
At this stage it probably feels impossible to invest enough to provide a large enough amount that will make much difference to your lifestyle in say 5 years time. Don’t be so sure; the miraculous properties of compounding interest will surprise you. Even if the figures seem a bit fairy tale today, once the process starts to “snow ball” you’ll be kicking yourself you didn’t do this sooner!
There’s two types of investment for retirement – lump sum and annuity.
Lump sum is where you construct your investment(s) to mature on a certain date.
Annuity is where you arrange them to mature in stages, providing an income or income supplement.
Of the two, you should go for annuity because:
- Down the track, governments will be looking for ways to exclude people from the pension and the first thing they will target will be people with large sums of money – lump sums.
- Lump sums have a habit of looking huge at first. You are tempted to spend a little on luxuries then suddenly wake up that the sum wasn’t so large and there’s not enough to live on for the next 10 years or so. Just ask anyone who has taken a redundancy package!
- Governments will possibly penalize people who have disposed of lump sums too. It’s a common practice for people approaching the pension age, to blow their savings on a cruise, so they are poor enough to qualify for a pension. It’s only a matter of time and governments will devise a way to penalize these folks.
- Because annuities don’t withdraw all the investment, the remainder left, keeps investing earning interest, thus in the long run you get back more for your outlay, from an annuity, than a lump sum.
To be a useful investment strategy, the investment must “snowball”. This means it has to reach a certain amount that it’s returns will pay for more new units of investment.
If I can only buy my investment in lots of $10, then I need to build up the number of $10 units to the point that the interest will buy another $10 unit. If I never add any more money, the investment will grow regardless – it’s snowballing.
When planning any investment, work out when the returns will reach this self replicating stage and make this your first investment target.
Once you start your investment off, you will discover there are little delightful surprise moments where things happen that you hadn’t foreseen. For example, I planned to buy 4 units or notes in P2P loans per month. I had designed a table that showed how they would compound over their 3 and 5 year life spans and how much I would make. However, for all my maths work, I was way off the mark. As repayments came in, I used them to buy more units, in addition to the 4 per month. My annual goal was attained in only 7 months!
We think we understand compound interest but until you actually get it working for you, it’s difficult to imagine the effects of the compound interest compounding on itself, buying more investments which compound on themselves to buy more units and so on.
In the next installment, we’ll look at one real life example and you’ll see that it is possible for anyone to do this.