The Snowball Effect of Retirement Savings

If there was one financial move that I executed well during my first few years of professional life, it was my decision to save heavily for retirement right off the bat. My first post-college employer offered a great retirement plan and offered robust matching and my mentor, whom I trusted deeply, told me I should go in there on the very first day and contribute enough to get every drop of that matching money, which I did. Thank goodness.

At first, the decision to contribute felt like a monumental one, one where I had total control over the situation. My total contribution was about 20% of my salary and that felt like a lot.

I started contributing right at the end of the recession of 2002 and, for the next six years, I contributed steadily to my retirement plans (across two different employers), receiving matching at both places.

In 2008, I stepped away from that career path and moved to my own, starting a Roth IRA and contributing to that without matching because I’d seen the power of those contributions.

Over the years, I’ve watched those initial contributions grow and shrink and grow again. I can’t add more to those accounts at this point, but I can certainly watch them grow like a terrarium inside of a glass bottle, and I’ve learned a few things along the way.

For starters, for most of the last several years, those investments have grown more each year than I ever contributed to them in a single year, without me putting a drop in there. I personally contributed between $5,000 and $7,000 a year to retirement in those early years and those accounts grew by more than $7,000 a year on their own most of the past several years. This is a function of the power of compound interest.

Another interesting note: I’ve contributed more to my Roth IRA than I ever did to those accounts, yet the balance of my Roth IRA is lower in total than those older accounts. This is, again, a function of the power of compound interest, and taken together, it should be clear to anyone that it makes a ton of financial sense to contribute as much as you can as early as you can to your retirement savings.

However, that’s not really what I’m writing about today.

As you progress down the road to retirement, the contributions you make have less and less of an impact and the ins and outs stock market has more and more of an impact.

Let’s say, for the sake of convenience, that you have an investment account that returns either 10% per year and -20% per year. You have five years of 10% returns and then a sixth year of -20% returns and then the cycle repeats itself.

You contribute $10,000 at the start of year one of this cycle, and that’s all.

At the end of year one, where you earn 10%, you’re left with a balance of $11,000.
At the end of year two, where you earn another 10%, you’re left with a balance of $12,100.
At the end of year three, where you earn another 10%, you’re left with a balance of $13,310.
At the end of year four, where you earn another 10%, you’re left with a balance of $14,641.
At the end of year five, where you earn another 10%, you’re left with a balance of $16,105.10.
At the end of year six, where you lose 20%, you’re left with a balance of $12,884.08.

As you can see, over those six years, you earned $2,884.08. You could have altered that return a little by contributing to a different investment – something that returned 7% a year every single year would have earned you $5,007 over that timeframe, for example. That’s a solid difference, but it’s not a huge one. The investment you choose will definitely make a difference early on, but the difference isn’t enormous. Your earnings difference over six years on that $10,000 initial investment will probably range by a thousand or two if you’re comparing similar investments.

Now, let’s look at a different example.

At the end of year one, where you earn 10%, you’re left with a balance of $11,000. You invest another $10,000 at this point, so your new contribution makes the balance go up 90.9%.

At the end of year two, where you earn another 10%, you’re left with a balance of $23,100. You invest another $10,000 at this point, so your new contribution makes the balance go up 43.3%.

At the end of year three, where you earn another 10%, you’re left with a balance of $36,410. You invest another $10,000 at this point, so your new contribution makes the balance go up 27.5%.

At the end of year four, where you earn another 10%, you’re left with a balance of $51,051. You invest another $10,000 at this point, so your new contribution makes the balance go up 19.6%.

At the end of year five, where you earn another 10%, you’re left with a balance of $67,156.10. You invest another $10,000 at this point, so your new contribution makes the balance go up 14.9%.

At the end of year six, where you lose 20%, you’re left with a balance of $61,724.88.

What’s the point of this illustration? Early on, your contributions make an enormous difference to your balance, but as time goes on, your contributions gradually become less and less important. After several years, most of the time the ins and outs of the stock market will have far more effect on your savings than your contributions. Your contributions have a smaller and smaller impact in terms of percentage, but the impact of the market stays the same in terms of percentage. Eventually, your contributions by percentage are substantially below the impact of the return on your investment.

In other words, once you’ve contributed for several years, your investments, if put into something reasonably aggressive, will start to grow so fast that in a typical year they’ll earn more on their own than you contribute. This gets more and more and more true over time, because as your investment grows, the annual returns grow.

What this feels like to me is pushing a snowball down a hill. At first, you have to really push and push and push a snowball around to make it sufficiently big, but there comes a point where that ball starts to have momentum on its own and it starts to roll on its own without you having to keep pushing it. You can keep pushing it, but you’re adding less and less and less force to that snowball rolling down the mountain and it’s picking up more and more and more steam on its own.

It’s at this point that making a good investment choice becomes increasingly important. When your balance on your account is $1,000, the difference between a 9% return and a 10% return is just $10. When the balance on your account is $100,000, that difference jumps to $1,000. Furthermore, that difference accelerates over time because that return is reinvested.

What’s the lesson here? The absolute most important thing you can do for your retirement savings is to just start contributing now. Don’t worry about choosing the perfect investment option. Just start contributing as soon as humanly possible. The earlier you start, the quicker you can get your retirement savings snowball big enough that it starts rolling down the mountain on its own momentum.

Later on, it will make sense to start looking more carefully at your investment options, not so much because a strategy change is in order, but to make sure you have your money in an option that charges low fees. I have every drop of my retirement savings in index funds for this purpose – they’re low fee investments that basically just match the overall stock market.

However, you don’t have to worry about that right now if you haven’t even started saving. The most important thing, by far, is that you get started right away. That’s far more important than what investment you choose. You can sit there blindfolded and choose one at random and as long as you eventually get around to figuring out which one you want in the next several years, you’re going to be in far better shape than waiting.

Start now. Start your snowball. Contribute something to retirement and start doing it consistently. Don’t worry about the specific investment that much, at least not right now. You’ll never regret this.