The compound interest effect: your ally for retirement provision

Last update: 17.09.2024 08:35

Do you know the game of chess? And would you like to earn more money with money? We explain how chess, the compound interest effect and your pension provision are connected. Read on and learn how you can make more of your money with little effort: how you can make your money work for you.

4 plus 4 equals 8, and another 4 equals 12, which is linear. 4 times 4 equals 16, and multiplied by 4 again equals 64. That is exponential, exponentiated, a multiple.

Let’s take a look at the effect of exponential growth with an anecdote from the Arab world. Legend has it that an advisor to an Indian ruler invented the game of chess. Although the king plays a central role in chess, he is lost without his pawns and officers. To thank him for his wisdom and entertainment, the ruler granted his advisor a free wish. Sissa bin Dahir asked for grains of wheat, twice as many in each field as in the previous one. The ruler granted him this wish. After a few days of calculating, the grain master realized that he could not keep the ruler’s reckless promise. The amount owed was more than a thousand times the annual wheat production of our time.

The anecdote shows very clearly how large the numbers become through exponential multiplication. Einstein was therefore also credited with the quote that compound interest is the greatest mathematical invention of human thought. Even if it is now considered proven that this is only an attribution after his death, this does not change its powerful leverage effect.

The compound interest effect is the basis for making money work for you. But how exactly does it work? Interest is an amount calculated as a percentage that increases the interest-bearing sum (assets and debts) after a certain term. As assets or debts increase as a result of interest, the percentage interest refers to a larger sum in the next interest calculation. Interest credited or charged therefore increases annually. Compound interest therefore arises from the fact that you receive interest on the previous year’s interest in the following year if you directly reinvest the interest received.

The compound interest effect then leads to the assets doubling after a certain period of time and later growing exponentially – due to the interest payments. Incidentally, although the compound interest effect is called this, it does not only apply to fixed-interest investments. Income from shares (i.e. dividends) also generates additional income in subsequent years if you reinvest it in shares immediately after distribution. Money makes money.

Caution: the compound interest effect plays against you with debt. Debt becomes more debt if you don’t make any repayments (ongoing interest payments and/or repayments).

The amount of compound interest depends on the following factors. Firstly, the initial assets that you invest at the beginning or draw down as a loan. Secondly, the amount and frequency of further deposits (so-called savings installments). Thirdly, the investment horizon, i.e. how long you invest your initial assets and savings installments. And fourthly, the interest rate (the return) that you receive or pay as interest on a loan. Let’s take a closer look at this.

The following three principles therefore apply to the compound interest effect, each separately and all together.

• Principle 1: The greater your initial assets, the more your wealth will grow.
• Principle 2: The longer you invest , the more your assets will grow.
• Principle 3: The higher the interest rate, the more your assets grow.

If you save assets for your retirement, it is important that they grow with compound interest and that you reinvest the interest payments or dividend distributions immediately. Only then will you benefit from the compound interest effect. This is because annual inflation (currency devaluation) also leads to an exponential loss of purchasing power, as a kind of counterpart to the compound interest effect. So if you want to maintain and increase the purchasing power of your assets, you also have to increase them exponentially via compound interest.

The compound interest effect is generally dramatically underestimated. So let’s take a look at the example of Philipp (25) and Daniel (45). Both start saving money for their old age.

Daniel has 20 years left until retirement, Philipp 40 years. Let’s assume that they both save the same amount each month and have the same starting balance. In this case, Philipp will have saved three times as much as Daniel. If Daniel wants to achieve the same level of assets as Philipp despite starting later at the age of 65, he will have to save three times more than Philipp each month. The application of principle 2 shows how important it is to start saving for retirement early.

Philipp becomes a millionaire

Let’s look at another calculation using Philipp as an example. If he invests the maximum amount of CHF 6,768 (as at 2018) from pillar 3a in securities each year with a starting balance of CHF 6,768 and achieves the historical average return on the global equity market (MSCI World), he will be a millionaire after 35 years. In other words, 5 years before the current retirement age. He has only paid in just under a quarter – the remaining three quarters are compound interest!

Reto’s example shows the impact of Principle 3. His long-term investment horizon allows him to build up his 3rd pillar pension provision with equity funds. He wonders what effect the difference in fees between active and passive funds (ETFs) actually has in Swiss francs. Because for him, more fees mean nothing other than less return on his assets. Reto compares a passive and an active 3a investment fund with an equity allocation of 75% each. The difference in fees and therefore returns of 1.45% has a significant impact in the long term: Reto’s final assets increase by around 30% with the cheaper product.

We have also shown the effect of another small measure, in this case switching the 3a payment from the end of the year to the beginning of the year, using Reto as an example. This is also an application of Principle 2. By making regular 3a payments at the beginning of the year, Reto ends up with around 15% more than if he had paid in at the end of the year. Would you have thought that? Compound interest makes it possible.

The concept of the compound interest effect is to earn more money with money: capital does not increase linearly, but exponentially. The exponential effect is dramatic and is regularly underestimated. Even though it is called “compound interest”, the effect also works when reinvesting dividends or debt. To maximize the effect for you, you should pay attention to the following:

• Maximize your initial assets (principle 1): It’s better to save more than less. A budget and tips help you get started now. After all, finding the right balance between today’s needs and tomorrow’s desires is a major challenge. Perhaps one of the strategies from the marshmallow test will help you cope?
• Profit from the highest possible return (principle 3): Look for an investment whose return/risk profile suits you and optimize its costs. This is because small differences in costs or returns have a major impact over long periods of time.
• Discontinue compound interest on loans: Remember that the compound interest effect also works for overdrafts or consumer credit. And it works against you in favor of the bank. Therefore, avoid taking them out and repay existing ones as quickly as possible.