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You could take care of your children’s retirement

The power of planning ahead.

Many investors obsess about returns. They want to know which asset class or which fund manager is outperforming because they want the highest possible growth on their money.

This is not illogical. Anyone putting their money to work by investing it should want to know that it is delivering a good return.

It does, however, place too much emphasis on something that is entirely out of their control. How the markets perform in future, or whether a fund manager will beat the index or its peers is not something that anyone can foresee, or influence.

This focus on performance also tends to be short term in nature. Investors want to know what their returns have looked like over one year, or three years, or even five years. Yet investing is never about those kinds of time frames. It is about benefiting from market growth over decades.

Plus, in reality, when investing over the long term, how markets or fund managers perform is not the most powerful influence on the outcome. Rather, it is time itself. It is benefiting from the power of compounding – earning growth on top of growth.

Control what you can

Investors who appreciate this also understand that this is something that is in their control. The earlier they start, the greater the effect of compounding will be.

This can be illustrated by a simple example.

Twin brothers Fred and Bob both start working on the day they turn 20. Fred immediately saves R500 every month and does so for the next 10 years. At the age of 30, however, he stops.

Bob, on the other hand, delays saving until the day he turns 30. From then on, he saves R500 every month until he and his brother both retire at the age of 60. Both of them receive the same annualised return of 10% on their investments.

Over this full period, Fred would have put away R60 000. Bob would have saved a total of R180 000 – three times more. Yet, because Fred started earlier, his investment would have grown to nearly double that of his twin brother’s.

The power of time
  Fred Bob
At age 20 R500.00 R0.00
At age 25 R39 863.85 R0.00
At age 30 R104 629.53 R500.00
At age 35 R172 147.90 R39 863.85
At age 40 R283 236.48 R104 629.53
At age 45 R466 011.51 R211 189.09
At age 50 R766 732.90 R386 512.49
At age 55 R1 261 512.49 R674 973.65
At age 50 R2 075 577.77 R1 149 581.36

As this table shows, despite making more contributions, Bob is not able to catch up.

In fact, if Bob (and his descendants for generations to come) never increased the R500 contribution, he (or they) could never close that gap. The 10-year head start that Fred had on them means that his money would forever continue to compound at a faster rate than they can top up their capital.

Give it time

This is a hugely significant fact, and one that Nedgroup Investments recently used in another rather mind-boggling theoretical experiment.

Nic Andrew, executive head of Nedgroup Investments, asked what would happen if the parents of twins, such as Fred and Bob, set up tax-free savings accounts for them on the day they were born and then immediately began making the maximum allowed contribution, which is currently R33 000 per child, per year. The lifetime cap on a tax-free account is currently R500 000, but Nedgroup Investments assumed that the government would increase this over time, as this is what has tended to happen around the world.

If the twins’ parents continued to save the R33 000 per child each year until they turned 18, they would have invested about R600 000 for each of them. Since the intention is that this money is for the long term, it would be 100% in growth assets – local and international equities. Historically, these have provided returns of 7% above inflation over long periods.

At this point, two important things happen. The first is that the parents stop adding to the investments. The second is that Fred and Bob don’t withdraw the money to buy themselves matching BMWs. Instead, they leave it where it is and allow it to compound.

The result, as Nedgroup Investments found, would be spectacular.

Making it work

“Amazingly, by investing a relatively small amount early, not withdrawing and instead compounding over a long period of time, by the time the twins reach retirement at 65, the balance would have grown in today’s money to over R20 million,” says Andrew. “This means the retiree twins could each withdraw R130 000 per month in today’s terms and the money would last until they were 100.”

And, significantly, those withdrawals would be entirely tax-free.

To put that in context, in order to match that outcome, Fred and Bob would have to start saving R3 700 per month from the day they turn 18, and increase that contribution every year by the rate of inflation. If, however, they were instead given this gift by their parents, they would never have to save for retirement at all.

That, in turn, means they could save for their own children in the same way. Just like their money would be compounding, the social impact too would be compounding.

“The point of this story is not to encourage a new generation of Trust Fund Children – it’s simply to illustrate how profound the effects of long-term saving can be,” Andrew notes.

“This is a fantastic example of three fundamental concepts of successful investing: the magic of compounding, especially over very long periods; the importance of investing sufficiently in growth assets that earn returns well above inflation; and ensuring that taxes and costs do not erode your net return.”

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What a brilliant idea. An eye opener.

Been thinking about doing exactly that but you’d hate to use up your child’s tax-free allowance if something unexpected happens.

Fred had a market crash in his first ten years…these calcs are only good on paper…not in the real world

It worked for me with at least 4 crashes during the period. In the late eighties mortgage rates even peaked at 21%. I had two jobs. The one job was collecting money at a night club called “Grab a Granny” which paid R15 per night. I am now retired and had paid off my mortgage in 10 years and thereafter saved half my mortgage in unit trusts. When the crashes occurred, I received more units from my investments. The issue was time in the market and not timing the market. I now realize that had I invested more in unit trusts ten years earlier and paid off my bond in 20 years, I would have earned more money. I retired at the age of 56 and I am still living comfortably in my house which I bought in the eighties.

Thanks for this article. The point, if you provide for the retirement of your children and they for theirs, then your descendants would be much wealthier. And that tax free savings will potentially save you millions in years to come.

What I simply do not understand is: why do I have to make the lifelong sacrifices of saving for my children to squander after my death…. I will enjoy the sweat of my brow and so should they… unless I have plenty then they will benefit.

If there was a market crash in the first 10 years Fred would actually be even better off because he would have bought more shares at lower prices, since he was making regular contributions at this point.

If there was a market crash in the second ten years, that would have had more of an impact on him than Bob. However, the time he had to recover from it would still likely put him ahead.

Easy to talk about. Not so easy if you don’t even have R2 to put away.

It is a lovely story, and trying to emphasize the value of saving, I get it !

However, who can save R 500 per month (don’t know what % of salary this is).

Whether you are a school leaver (unemployed) or graduate, the reality is you need a car – even a small cheap, used vehicle and there are other living expenses. It is even worse ( cash flow that is) when you get married and start to raise a family.

Nice fairy tale, devoid of reality.

Great article. I find it quite hard to get millennials to understand the concept of time and money.

The advice is great but in practice it might be problematic. Once that child reaches 18 then he or she will have control over the money and will be able to withdraw at will.

Not a lot of people know that you can do an RA for a child from age 1. So doing an RA for a child will prevent them from withdrawing before age 55. The draw back will be that that income will become taxable. It’s stll a great gift to give a child or a grandchild.

This is assuming that you have the most awesome bank account in the world.

Drop the interest rate to the more realistic 5% and do the calculations and you have a different picture.

Then go into the real world where fund managers and advisers are pimping “products” and market them in a way that deceives Joe Public that all of their products will perform in the same manner as their top performing fund did over the past 5 years, and you have a different problem.

Do the calculations based on the real world values of 10% returns on year and 2% the next and then -5% the next and then 2% and see what the outcome is.

All the calculations look lovely on paper, but the real world is very different.

I will be retiring in New Zealand.

Another nonsense article! 2 million 30 years ago was a fortune,today it’s peanuts,what’s it going to be worth in 30 years time!

Good thing I did not read the article. Sounds like it would have been a waste off time.

Bruce – I assume you are part of the “1%” who is dramatically out of touch with reality if you think 2 million is “peanuts” for most people.
Chris Stoffel – read the article and don’t trust Bruce’s comment which is nonsensical.

I like how they both get younger again in the last line. From 55 to 50. 😛

Please hook me up with that “immortality drink” seller.

2 problems. 1. A long term view on the ZAR. 1. A long term view on the ANC (both in terms of their ability to stuff the economy up, and to grab your assets when it’s stuffed). Imagine having saved Zim dollars for 20 years. You’d be a right billionaire.

Cynical me : redo the numbers so that the brothers earn 12% instaed of 10% after fees…

Realistically, spending habits would have more of an impact. Do the math on simply ‘upgrading’ the car every 7y instead of 3y.

On the other hand : the kids should sort their own retirement otherwise you REALLY failed as a parent

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