Understanding the Impact of Compounding Increases Savings Rates
Knowing how big of an impact compounded returns will have on retirement savings can prompt investors to save more money. In a study scheduled to be published in the November issue of the Journal of Marketing Research, researchers came to this conclusion after looking into how understanding the exponential growth created by compounding affects savings rates.
The study relied primarily on college students, though employees of a Fortune 100 company were used for one of the experiments. Authors Craig McKenzie of the University of California, San Diego, and Michael Liersch of New York University found that many participants misunderstood compounding and the costs of delaying saving for retirement. They also found that when shown the positive effect of long-term compounding, participants were motivated to increase their savings.
Many college students, and likely many college graduates, incorrectly assumed that savings grow linearly, rather than exponentially. The result was that the median estimate of what an account balance’s size would be was less than 10% of what it would be after a period of 40 years with a given projected rate of return.
Study participants also incorrectly assumed that it is easy to make up for lost time by saving more. Many students, even those who understood how compound returns work, wrongly assumed that they could delay savings until they advanced in their careers. This erroneous assumption can lead to lost cumulative savings that are difficult to make up when periods with high rates of return are skipped.
To determine whether knowing how much one will have at retirement will motivate someone who is currently working to adjust their savings, the authors surveyed employees of a Fortune 100 company. Employees who were shown the estimated account balance of their 401(k) at retirement were more motivated to increase their savings. The authors found that even when the ending balance was larger than needed, participants still wanted to increase their savings.
The study shows that even when the math is understood, many people still have a hard time grasping the concept of exponential growth in savings. The study’s authors concluded that, by showing the dollar-value impact of compounding, individuals can be motivated to save more at an earlier time in their lives.
Source: “Misunderstanding Savings Growth: Implications for Retirement Savings Behavior,” Journal of Marketing Research, November 2011.