Commentary

Tapping the Power of Compound Interest

Imagine that back in 1926 your grandparents scrimped and saved and placed $100 in a trust fund where the money would accumulate for their grandchildren. And imagine that the $100 remained in the fund for some 70 years earning the average rate of return of the stock market. How much money would you, the grandchild, have today from that initial $100 investment?

The answer, incredible as it may sound, is $266,139. That initial $100 gift from your grandparents would allow you to retire at age 65 and draw down the investment with annual payments that would virtually match or even surpass what you can expect from Social Security.

Or consider this scenario: Back in 1950, when they were just starting out in life, assume your parents placed $1,000 in a mutual fund. Let’s say that they retired in 1998 at age 69. That single deposit of $1,000 would now be worth $217,630. And that assumes your parents never saved an additional penny for the rest of their lives. Who needs Social Security?

Let’s go back to our grandparents. What if they and then your parents had put $100 every year into an account for 72 years? At the end of 1998 that account would have been worth $2.36 million. Now that’s a retirement nest egg. If starting in 1950 your parents had put $1,000 per year into a stock fund paying an average rate of return, they would have $1.86 million today. Odds are that they paid much more than $1,000 a year in payroll taxes but won’t get anywhere near $1.86 million in Social Security retirement benefits.

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

 


Tax free individual retirement accounts (IRAs) should be made available to all Americans regardless of their incomes and with no limitation on how much they can save.


To verify whether that rate of return could possibly be right, I consulted Jermey Siegel’s new bible on the financial markets, Stocks for the Long Run (McGraw Hill, 1998). There I found basically the same conclusion. Siegel reports that for roughly the past 200 years the average annual rate of return in the stock market has been more than 10 percent. There has never been a 40-year period in American history when the markets have deviated significantly from that long-term trend.

It is often said these days that lower- and middle-income Americans should avoid the stock market because it is so “risky.” The facts suggest that stocks are not very risky at all if held for the long term. Over time, even the poorest Americans can accumulate substantial wealth by investing. My favorite example is Theodore R. Johnson, who 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, and when he reached the age of 90 last year his net worth was a cool $70 million.

Alas, there is a catch to all of this. We have forgotten about taxes. In the example of the grandparents and parents who put $100 a year in a mutual fund starting in 1926, the $2.36 million would have shrunk to $973,000 if they had been in the 15 percent tax bracket. Even at this lowest income tax rate, taxes would eat up 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 $2.36 million but just $101,000. No, this is not a misprint. Taxes would have confiscated 95 percent of the return!

Economists and political pundits in Washington sermonize that Americans should save more. Lester Thurow of MIT moans that America had “negative savings rates in late 1998.” But why should we save? The tax code punishes us for thrift. The double and triple taxes on saving claim up to 90 percent of the rewards from investing. We are rewarded for consuming as much as possible right now.

There is a logical policy prescription: universal savings accounts. Tax free individual retirement accounts (IRAs) should be made available to all Americans regardless of their incomes and with no limitation on how much they can save. Presidential candidate Dan Quayle has proposed just such a plan. More than 25 million Americans — mostly low- and middle-income workers — have IRAs, but stupidly we limit the amount they can place in those accounts to a few thousand dollars. It is a fundamental principle of all tax reform proposals — including the flat tax and the national sales tax — that savings should never be double taxed.

If Congress would allow taxpayers to build up more wealth in untaxed universal savings accounts, Americans could be weaned from paternalistic government programs, like Social Security, Medicare, unemployment insurance and student loans. The Quayle plan would allow workers to take funds out of IRAs to pay for educational expenditures, health care costs and, of course, retirement.

We as a nation will save more and take more control of our own destinies and those of our families if Congress will simply let us. The best children’s program that Washington could possibly devise is one that allows Americans to build up wealth for their own children and grandchildren. It doesn’t take a village to raise a family, but it may take a smarter tax code.

How Income Taxes Punish Savings
$100 per Year Investment
First Year of Investment No Income Tax 15% Tax Bracket 50% Tax Bracket
1926 $2,360,668 $973,253 $101,482
1950 185,883 98,520 18,824
1974 20,367 13,276 4,112
Source: Savers & Investors League, www.savers.org, 1998.
Stephen Moore is director of fiscal policy studies at the Cato Institute.