Commentary

Tapping the Power of Compound Interest

By Stephen Moore
This article originally appeared in National Review.

Albert Einstein is purported to have once remarked that the most powerful force in the universe is compound interest. My favorite example of the power of compounding effects was recounted recently by George Gilder.

The Emperor of China was so excited about the game of chess that he offered the inventor one wish. The inventor replied that he wanted one grain of rice on the first square of the chess board, two grains on the second square, four on the third and so on through the 64th square. The unwitting emperor immediately agrees to the seemingly modest request. But two to the 64th power is 18 million trillion grains of rice—more than enough to cover the entire surface of the earth. The clever inventor did not gain all the rice in China; he lost his head.

Of course, the power of compound interest is most relevant these days when it comes to managing our personal finances. Imagine for a moment that back in 1927 your grandparents placed $100 in a trust fund for you. And imagine that the principle and the interest remained untouched for the next 70 years. If the trust fund earned the average rate of return of the stock market, how much money would you have today from that initial $100 investment?

The incredible answer is $263,000. From a mere $100 gift from your grandparents you could draw down that account upon retirement in the form of annual payments that would virtually match or even surpass what you can expect from Social Security.

Or consider this scenario: Back in 1950, when he was just starting out in life, assume your father placed $1,000 in a mutual fund. Let’s say in 1997 at age 68 he retired. That $1,000 would have grown to $217,630. And that assumes he never saved an additional penny for the rest of his life. Who needs Social Security?

If starting in 1950 your father had put $1,000 every year into a stock fund paying an average rate of return, he would be very rich today. The stock fund would be worth $1.85 million. Your parents could have a higher income just by living off the interest from this account than from their Social Security checks, and they could leave the entire $1.85 million to their children.

When Tom Kelly, director of the Savers and Investors League showed me this data (check out their spreadsheet for yourself at www.savers.org) I was in a state of disbelief. Kelly found that regardless of “the mutual fund’s volatility over time, a fund’s total return from any start year (i.e., 1930, 1950, 1970, etc.) to 1997, was virtually always 11% per annum.”

To verify whether that rate of return could possibly be right, I consulted Jeremy Siegel’s indispensable bible on the financial markets, Stocks for the Long Run (McGraw Hill, 1997). There I found basically the same conclusion. Siegel reports that for from the day the New York Stock Exchange opened its doors, through the end of 1997, the average annual rate of return on stocks has been more than 10 percent. Siegel finds that there has never been a 40 year period in American history when the markets have deviated significantly from that long-term trend.

These findings demonstrate why Social Security is such a godawful deal for workers. Social Security’s pay-as-you-go benefit structure, a scam in which the payroll tax money is spent on retirees virtually the same day it is collected from workers, robs Americans of the awesome power of compound interest. There is no compounding effect from your Social Security payments, because there is no money actually being saved.

The findings from Kelly and Siegel’s research also blow some pretty impressive holes in many conventional myths about financial markets. The most prevalent fallacy is that the stock market is a “risky” place to park your retirement funds—particularly if you are a low income worker. The fallacy here emanates from a failure to distinguish between the short run and the long run. It is entirely true that in the short term the stock market has all the volatility of Dennis Rodman’s prickly personality. But over the long run, say 25 years or more, the U.S. capital markets are about the most reliable, risk-free place to put your money other than under your mattress—and you’re going to get a much nicer return with stocks. When liberal do-gooders tell low income Americans that stocks are unsafe for building up wealth, they are perpetuating a pernicious lie that keeps poor people poor.

Over the long run, even minimal investments can accumulate into a substantial wealth build-up. My favorite real life example is Theodore R. Johnson who, according to a recent The Chicago Tribune profile, never made more than $14,000 a year working at United Parcel Service. But he plowed every penny of savings he had back into UPS stock (he really should have diversified), and when he reached the age of 90 last year he shocked his relatives and friends by announcing that his net worth was a cool $70 million.

Now for the bad news. Up until now we have forgotten about our friend, the IRS tax collector. Let’s go back to the example of your parents who conscientiously placed $1,000 a year in a mutual fund starting in 1950. Recall that with no taxes applied, they now have a cool $1.85 million; but if they were in just a 15 percent tax bracket, their nest egg shrinks to $973,000. Even taxed at this lowest income tax rate, taxes would snatch 59 percent of the gain. What if they paid a combined federal and state income tax rate of 50 percent, as many Americans do today? Then the nest egg would not be $1.85 million today but just $188,000. No, this is not a misprint. Taxes would have confiscated 89.9 percent of the return! The table below demonstrates how the tax code penalizes savings:


            $1,000 Year Investment Starting in:

                                 1950         1974
         Tax Free Account    $1,855,000    $203,000
         15% Tax Bracket        985,000     133,000
         Actual Tax Bite %          47%         35%

         50% Tax Bracket        188,000      41,000
         Actual Tax Bite %          89%         80%

    Source: Savers & Investors League, www.savers.org, 1998.
      

Economists and political pundits in Washington sermonize that Americans should save more. Last month Lester Thurow of MIT recently thumped Americans on their knuckles with his ruler for having “negative savings rates in late 1998.” Why don’t Americans save? he asks in perplexity. The brief answer is: Why should we? The tax code punishes us for thrift. The double and triple layers of taxation on saving imbedded in our income tax system claims up to 90 percent of the rewards from saving and investing. We are rewarded for purchasing as many VCRs, Nintendos, cellular phones, Sony entertainment centers, and microwaves, as we can possibly stuff in our homes.

There is a logical policy prescription: Universal Savings Accounts. No, I’m not talking about the White House’s brain storm of a new means-tested entitlement program whereby the government deposits a free check in Americans’ bank account each month. What we need is Congress to make tax free Individual Retirement Accounts (IRAs) much more widely available to all Americans regardless of their incomes. Congress should build on the awesome popularity and success of the Roth IRAs, began last year. Under a Roth IRA you pay tax on the money when you place it in the account, but you never pay tax on the equity build-up in the fund or when you eventually take the money out. Today, more than 25 million Americans have IRAs.

Not surprisingly, IRA expansion plans are proliferating. Presidential candidate Dan Quayle has proposed super IRAs in which the annual contribution limits would be doubled to $5,000 per person. Democratic Senator John Breaux of Louisiana has a terrific bill that would allow unlimited tax free deposits into IRA accounts. (Psst, don’t tell any liberals but if Breaux had his way we would finally have the tax reformer’s dream: a consumption tax.)

If Congress would allow taxpayers to build up more wealth in untaxed IRAs, Americans could be weaned from paternalistic government programs, like Social Security, Medicare, unemployment insurance, and student loans. The Quayle plan, for example, would allow workers to take funds out of IRAs to pay for educational expenditures, health care costs and, of course, retirement. This is an ingenious back door strategy for privatizing these activities.

IRAs and privatized Social Security accounts would allow Americans to save more and take more control of their own destinies and those of their families. The best children’s program that Washington could possibly devise is one that allows Americans to build up wealth for their own kids and grandkids. It doesn’t take a village to raise a family, but it may take a smarter tax code—one that taps the power of compound interest.

Stephen Moore is director of fiscal policy studies at the Cato Institute.