Your nest egg is made up of two component parts: the contributions you diligently make to your retirement accounts throughout your career, and the investment returns that those contributions earn for you.
Not surprisingly, your contributions — and those of your employer, if you receive matching funds in your 401(k) — initially dwarf what your investments earn in the market. But if you save regularly and invest sensibly, you will eventually hit a crossover point where your investment gains exceed the contributions you make to your accounts.
At that point, you’ll be in the sweet position of watching your investments effectively do the bulk of your savings for you. And this is what you should be aiming for.
That’s why a balanced, disciplined long-term approach that will successfully get you to this crossover point beats a strategy that swings for the fences and takes undue short-term risks.
How Long Before Your Investments Do the Heavy Lifting?
Here’s how this works: Let’s say you earn $45,000 a year, receive 2% annual raises and begin contributing 10% of your paycheck each month into a 401(k), where your investments earn a 6% annual return.
When you start out, your investment earn a mere pittance compared to the amount you’re socking away. The first month, in this example, you contribute $375 to your account, which racks up a grand total of less than $2 in investment gains for the month. Even after you’ve socked away a full year of contributions, or $4,500, your investments are kicking in only a bit more than $20 a month to your account balance, or only about 5% of the total amount you contributed that first year.
As your investment earnings begin to compound over time, however, they become an increasingly important source of growth in your account balance. At the end of five years, your investment gains amount to roughly a third of the monthly amount you’re contributing on your own.
By Year Eight, your investment earnings equal more than half of your monthly contributions.
Then, a little more than 13 years into this regimen, you hit that crossover point, when your investment gains start to exceed the amount you’re stashing away from your salary.
Specifically, in this scenario your investments would at that point be generating gains of more than $500 a month, surpassing the $485 a month you would be funneling into your 401(k) via payroll deductions. Your investments are now essentially doing most of your savings for you.
But you shouldn’t just shoot for a 13-year time horizon.
It’s only after your account’s value grows once you hit this threshold that things really begin to snowball, and investment earnings really start to leave your contributions in the dust. So you must have the discipline to stick with your retirement savings strategy well beyond this marker to really enjoy the fruits of compound interest.
In less than 10 years after arriving at this crossover point, for example, your investments would be kicking in more than double the amount you’re saving on your own.
In another seven years after that, your investments would be contributing triple what you’re socking away. And five years after that (or nearly 35 years into this regimen), your investments would be generating more than four times the amount you’re saving, or in this case roughly $2,900 a month vs. $720.
he amount of time it takes to get to the stage where your investments are adding more to your nest egg’s value each month than you are will depend on such factors as the rate of return your investments earn, how quickly your salary grows, and how committed you are to saving on a regular basis.
But the point is, you have to commit to saving diligently and investing prudently over 20 or 30 years before your investments will be the main lever of wealth building.
What Other Levers Should You Pull?
Of course, it’s also important to remember that your ultimate goal isn’t simply to cross the threshold where investment gains exceed what you contribute to your retirement accounts (or, if you qualify for matching funds, what you and your employer combined contribute).
It’s to build a nest egg large enough so you don’t outlive it in retirement.
So you want to be sure you save enough to support yourself throughout a retirement that could last upwards of 30 or more years.
For example, if you follow the regimen outlined above except you save only 5% of salary each year, your investment earnings will still eventually exceed your contributions. But after 40 years of saving and investing, you would have a nest egg worth only about $467,000 (about $136,000 in your contributions, plus nearly $331,000 in investment earnings).
