You can think of your nest egg as having two main components: ongoing contributions to your retirement accounts and the investment returns you earn on those contributions. Not surprisingly, your contributions (and those of your employer, if you receive matching funds) initially dwarf what your investments earn. But if you save regularly and invest sensibly, you should eventually hit a crossover point at which your investment gains exceed contributions to your accounts. You’ll then be in the sweet position of watching your investments effectively do the bulk of your savings for you.
Here’s an example: Let’s say you earn $45,000 a year, receive 2% annual raises and begin contributing 10% of salary each month to a 401(k) where your investments earn a 6% annual return. When you start out, your investment earnings are a mere pittance compared to the amount you’re socking away. The first month, for 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, for example, your monthly investment gains amount to roughly a third of the monthly amount you’re contributing on your own. By eight years, your monthly investment earnings equal more than half of your monthly contributions.
Then, a little more than 13 years into this regimen, you hit the crossover point, that moment when 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.
As your account’s value grows, things begin to snowball, and investment earnings really start to leave your contributions in the dust. 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, 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.
I’m not saying you can duplicate these results exactly. The 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 that if you save diligently and invest prudently, your investments will eventually start doing the heavy-lifting for you.
Of course, it’s also important to remember that your ultimate goal isn’t 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). Save 10%, however, and you’ll still come to that crossover point at the same time, but you’ll also end up with a much bigger nest egg, a bit over $933,000 (almost $272,000 in contributions plus roughly $661,000 in earnings). Boost your savings rate even further to 15%, and you’ll have an even more impressive stash of $1.4 million (almost $408,000 in contributions plus about $992,000 in investment gains).
It also pays to get an early jump on saving. In the scenario above, for example, it takes about 13 years to reach the point where investment gains exceed your contributions, and about 38 years before they’re more than five times as large. Begin saving at age 25 and you’ll achieve those milestones in your late 30s and early 60s respectively. If you wait until age 35 to start saving, your investment gains won’t start to outpace your own savings effort until you’re nearly 50 and you’ll likely retire before your investment gains are even four times as large as your own contributions, let alone five. In short, the sooner you start saving in earnest, the more quickly your investments will become a major contributor to your savings program.
Finally, you want to invest in a reasonable, disciplined way, by which I mean putting together a well-balanced portfolio of low-cost broadly diversified funds or ETFs that reflects your risk tolerance and can generate solid long-term returns. Give in to the temptation to invest in the latest fads or load up on investments with onerous fees and expenses, and it could take a lot longer to get to the satisfying position where your investments are doing most of your savings for you, or you might not reach that point at all.