Tapping the Power of Compound Interest

This article originally appeared in National Review.
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Albert Einstein is purported to have once remarked that the mostpowerful force in the universe is compound interest. My favorite example ofthe power of compounding effects was recounted recently by George Gilder.

The Emperor of China was so excited about the game of chess that heoffered the inventor one wish. The inventor replied that he wanted onegrain of rice on the first square of the chess board, two grains on thesecond square, four on the third and so on through the 64th square. Theunwitting emperor immediately agrees to the seemingly modest request. Buttwo to the 64th power is 18 million trillion grains of rice--more thanenough to cover the entire surface of the earth. The clever inventor didnot gain all the rice in China; he lost his head.

Of course, the power of compound interest is most relevant these dayswhen it comes to managing our personal finances. Imagine for a moment thatback in 1927 your grandparents placed $100 in a trust fund for you. Andimagine that the principle and the interest remained untouched for the next70 years. If the trust fund earned the average rate of return of the stockmarket, how much money would you have today from that initial $100investment?

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

Or consider this scenario: Back in 1950, when he was just starting outin life, assume your father placed $1,000 in a mutual fund. Let's say in1997 at age 68 he retired. That $1,000 would have grown to $217,630. Andthat 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 stockfund paying an average rate of return, he would be very rich today. Thestock fund would be worth $1.85 million. Your parents could have a higherincome just by living off the interest from this account than from theirSocial Security checks, and they could leave the entire $1.85 million totheir children.

When Tom Kelly, director of the Savers and Investors League showed methis data (check out their spreadsheet for yourself at www.savers.org) I wasin a state of disbelief. Kelly found that regardless of "the mutual fund'svolatility 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, Iconsulted Jeremy Siegel's indispensable bible on the financial markets,Stocks for the Long Run (McGraw Hill, 1997). There I found basically thesame conclusion. Siegel reports that for from the day the New York StockExchange opened its doors, through the end of 1997, the average annual rateof return on stocks has been more than 10 percent. Siegel finds that therehas never been a 40 year period in American history when the markets havedeviated significantly from that long-term trend.

These findings demonstrate why Social Security is such a godawful dealfor workers. Social Security's pay-as-you-go benefit structure, a scam inwhich the payroll tax money is spent on retirees virtually the same day itis collected from workers, robs Americans of the awesome power of compoundinterest. There is no compounding effect from your Social Securitypayments, because there is no money actually being saved.

The findings from Kelly and Siegel's research also blow some prettyimpressive holes in many conventional myths about financial markets. Themost prevalent fallacy is that the stock market is a "risky" place to parkyour retirement funds--particularly if you are a low income worker. Thefallacy here emanates from a failure to distinguish between the short runand the long run. It is entirely true that in the short term the stockmarket has all the volatility of Dennis Rodman's prickly personality. Butover the long run, say 25 years or more, the U.S. capital markets are aboutthe most reliable, risk-free place to put your money other than under yourmattress--and you're going to get a much nicer return with stocks. Whenliberal do-gooders tell low income Americans that stocks are unsafe forbuilding up wealth, they are perpetuating a pernicious lie that keeps poorpeople poor.

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

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 whoconscientiously 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; butif 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 59percent of the gain. What if they paid a combined federal and state incometax rate of 50 percent, as many Americans do today? Then the nest egg wouldnot 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 belowdemonstrates 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 thatAmericans should save more. Last month Lester Thurow of MIT recentlythumped Americans on their knuckles with his ruler for having "negativesavings rates in late 1998." Why don't Americans save? he asks inperplexity. The brief answer is: Why should we? The tax code punishes usfor thrift. The double and triple layers of taxation on saving imbedded inour income tax system claims up to 90 percent of the rewards from saving andinvesting. We are rewarded for purchasing as many VCRs, Nintendos, cellularphones, Sony entertainment centers, and microwaves, as we can possibly stuffin 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 newmeans-tested entitlement program whereby the government deposits a freecheck in Americans' bank account each month. What we need is Congress tomake tax free Individual Retirement Accounts (IRAs) much more widelyavailable to all Americans regardless of their incomes. Congress shouldbuild on the awesome popularity and success of the Roth IRAs, began lastyear. Under a Roth IRA you pay tax on the money when you place it in theaccount, but you never pay tax on the equity build-up in the fund or whenyou eventually take the money out. Today, more than 25 million Americanshave IRAs.

Not surprisingly, IRA expansion plans are proliferating. Presidentialcandidate Dan Quayle has proposed super IRAs in which the annualcontribution limits would be doubled to $5,000 per person. DemocraticSenator John Breaux of Louisiana has a terrific bill that would allowunlimited tax free deposits into IRA accounts. (Psst, don't tell anyliberals but if Breaux had his way we would finally have the tax reformer'sdream: a consumption tax.)

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

IRAs and privatized Social Security accounts would allow Americans tosave more and take more control of their own destinies and those of theirfamilies. The best children's program that Washington could possibly deviseis one that allows Americans to build up wealth for their own kids andgrandkids. It doesn't take a village to raise a family, but it may take asmarter tax code--one that taps the power of compound interest.

Stephen Moore

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