The physicist Albert Einstein reportedly referred to compound interest as the “eighth wonder of the world” – not a bad endorsement from someone who was no slouch at understanding the relative movements of objects.  Even if we in our everyday lives are not capable of Einstein’s depth of thought, we can all still benefit from his observation.  The compounding of interest (or any investment return) is a powerful force over time.  It is something we should all have working in our favour as we save and plan for the future because without it we will none of us have as much ease and comfort in our later years as we could have, or would like to expect.  Like many things in life, though, putting in place such a plan is simple, but often not necessarily easy.

The typical retirement plan involves a combination of income sources something like the pie chart below.

Retirement plan pie chartNational Insurance is a large part of the pie, but it is only one piece.  We will also rely on private pension assets, other tax sheltered assets such as Registered Retirement Savings Plans (RRSPs), and on other financial and real assets such as mutual funds and real estate.  During our working lives we need to build up these pieces of the pie so they will be there to support us when we have less income.

There are many factors determining how large your assets will grow by the time you want to draw from them, but the three most important are time, rate of return and taxes.

Time

We have all seen the examples of how saving $200 (or any amount) a month, every month results in the accumulation of a lot of money after 10 years; how the same programme extended over 20 years results in an exponentially larger value; and how after 30 years the amount has grown almost implausibly enormous.  Time matters, and the earlier we start with a structured financial plan the better off we will be.  Funny that we don’t all do it, then.  It is also funny how many plans get abandoned when they are no longer convenient for one reason or another.  Financial planning experts have found that structure helps. Company pension plans are great ways to “force” savings since deductions are made before we even see the money.  Mutual fund companies can also offer monthly purchase plans for regular accounts and RRSPs so that the money comes out automatically every month.

Rate of return

The return achieved on the assets in your pie is critical.  Inflation – currently running well over 5% in Barbados – will eat up a terrifying amount of your return over time.  The more you can earn over time the better off you will be, so it is important to invest for the long term and to be properly diversified.  Many people leave too much of their savings in the bank earning a low rate of interest.  Some money in the bank is good and appropriate, but long term savings should be invested in a diversified portfolio of bonds, shares and real estate to earn higher returns over time.  Indeed, if there is one thing the CLICO debacle has reinforced, it is that diversification matters.  If you have all of your assets lent to one institution, you are taking far more risk than you need to.  A large negative rate of return can undo many positive years that came before.

Taxes

They are inescapable, but there are ways to minimise them and we should all be doing what we can to do so.  Up to regulated limits, pension plan contributions are tax deductible, as are contributions to RRSPs.  This saves you tax now.  However, if you do not use the tax benefit each year, there is no going back in time to claim it in future years.  In these cases, we have to use it or “lose” it, and we should definitely plan to “use” as much as possible.  We should also remember that certain investments are taxed more beneficially than others in Barbados.  There is tax on interest, but no tax on capital gains.  This means we should, where appropriate, prefer to invest in assets that deliver capital gains as opposed to interest.

As a wise man once said, “Hope is not a strategy.”  A sound financial plan will take advantage of Einstein’s eighth wonder in as many ways as possible, for as long as possible.  This requires a little discipline and foresight up front, from us as individuals, and from employers who can help put in place structure for long term savings via pensions.  This is important any time, but it is especially critical in tough times when we are all tempted to spend a little more today, and rely a little more than we should on “hope” in the future.

About the Author

Peter Arender, CFA
Peter Arender, CFA -

Chief Investment Officer, Fortress Advisory & Investment Services