How well do you understand the magic of saving and compounding? Here’s a quiz to find out.
Background
Michael and Sara are engaged to be married. They agree on most things, but they haven’t talked about financial matters. Sara knows that fighting over money is a big cause of divorce, so she wisely decides to have some financial discussions with her fiancé before they get married.
Sara is a believer in saving money and wants to better understand how each of the following contributes to meeting savings (and retirement) goals:
1) annual salary increases
2) annual savings contributions
3) the rate of return realized on the investments of these savings.
Sara starts with some conservative assumptions as her base case:
1) Starting salary of $37,514, the average starting salary for a public-school teacher in North Carolina.
2) Annual salary estimated increases of 3.1%. This is set to match inflation expectations in #5.
3) She will put 2.0% of her salary into savings. She wants to start small.
4) She thinks a return on investments of 5% annually is reasonable, about half the long-term average of 10%.
5) She chooses a future annual inflation rate of 3.1%, a rate close to the long-term average.
Question 1
Using all Sara’s base case assumptions above, about how much would she have saved in 30 years?
a) Less than $55,000
b) About $65,000
c) About $75,000
d) More than $85,000
Question 2
Michael suggests to Sara that since she’s smart and a hard worker, she can do considerably better than a 3.1% annual increase in salary. He thinks she can double that to 6.2% every year. If she achieves that, keeping all her other base case assumptions constant, about how much more will Sara now have saved in 30 years?
a) 100% more, she would double her savings.
b) About $30,000 more
c) About $40,000 more
d) About $50,000 more
Question 3
Going back to Sara’s base case assumptions, Michael now suggests to her that she is too conservative with her investment assumptions. Given the historical stock market return of about 10%, he thinks she should at least be able to match that going forward rather than the 5% she’s assuming. If she achieves that 10%, keeping all the other base case assumptions constant, about how much more will Sara now have saved in 30 years?
a) 100% more, she would exactly double her money.
b) About $50,000 more
c) About $100,000 more
d) About $150,000 more
Question 4
Now it’s Sara’s turn. She thinks Michael is being totally unrealistic – too optimistic – and wants to go back to her original conservative assumptions. But now she asks a new question – how much would she have in 30 thirty years if she saved 10% of her salary?
a) About $177,000
b) About $277,000
c) About $377,000
d) About $477,000
Question 5
Michael has been following this discussion closely. He wants to know how much Sara would have in 30 years if his two “unrealistic” assumptions are proven to be correct and Sara puts 10% of her salary every year into savings/investments:
a) About $500,000
b) About $650,000
c) About $800,000
d) About $950,000
e) More than $1,200,000.
Answers: 1c, 2c, 3c, 4c, 5e.
For achieving future financial security, there is no substitute for regularly occurring contributions.
Trading total control of ongoing contributions for the uncertainty of future salary releases or hoped-for future investment returns is a trade you will live to regret. The magic of compounding over time applied to annual contributions and investment returns dramatically improves the odds of establishing a secure financial future for yourself.
It’s really that simple.