Time: Investing Friend or Enemy?
By A. Andrew Raub
Jack had a decision to make. As he examined his early retirement options, Jack realized that his pension plan offered both interesting as well as confusing options. He could take out all the money in the plan as a cash lump sum and invest it himself. Or, he could opt to withdraw a monthly income from the plan for the rest of his life and still have certain options to leave his wife an income in the event he should die before her. Which was the best deal? And how could he figure it out?
Economically, time and money are linked by a series of laws called the time value of money. These include the concepts of present value and future value, which are governed by the law of compound growth.
Present value is what you have today. Future value is the amount your present value will grow to in the future at a certain rate of interest. For instance, in Jack's case above, his present value, or original lump sum, was $200,000.
If Jack's choice were between a lump sum of $200,000 or an annual income of $20,000 for ten years, he would know that the pension plan was not going to pay him any interest—not a very good deal. However, if the plan offered $31,700 for 10 years, or $317,000 total—he could assume a 10 percent return. Jack considered the difference between accepting the plan's 10 percent return over ten years and the inherent risk of investing the lump sum on his own at 10 percent, and began thinking the plan sounded pretty good—but he called his advisor just to be sure.
"Actually, Jack," the advisor said, "you can earn more than the $317,000 the plan is offering."
"How?" Jack countered. "I don't want to take on the risk involved in a more aggressive investment than 10 percent."
"You won't need to. If you take the $200,000 lump sum and invest it for ten years at 10 percent, at the end of the ten years, you will have $518,800."
"Wait! Why is the total of the payments only $317,000, but I can invest the same present value at the same rate for the same number of years and earn over $200,000 more? That makes no sense. How can I earn more at the same percentage than the pension plan can?"
"It makes perfect sense, Jack. It's the law of compound growth."
Compound growth is the ability to earn interest on both principal and interest. With the pension plan, Jack withdrew or "spent" the money and forfeited the ability to earn interest on his interest. In the second case, he saved the original $200,000 and earned interest on both the $200,000 and on the interest as it accumulated. His ability to compound his return was worth more than his original principal in just ten years! This incredible law of compound interest is foundational in making financial decisions because time links risk and return. It determines investment mix and impacts your personal plans like no other investing factor.
So what does this mean for you? If you are building wealth, then the more time you have to invest, the lower the rate of return you will need to earn, and consequently, the lower the risk you will need to take. The Rule of Seventy-Two is a handy way of correlating rate of return and time. It answers the question: How long does it take money to double? This rule states that your money will double in value in any combination of the rate of return times the number of years that equals seventy-two. For example, $1000 will grow to $2000 in nine years at 8 percent, or in eighteen years at 4 percent, or slightly more than ten years at 7 percent.
However, if you are in the mode of withdrawing income from your investments, the rules still apply. The less you take out, the lower the return you require and the less risk you need to take on what remains. By putting time on your side, you can have more—more return and more peace of mind—with less investment capital, less risk, and less worry.
To learn more about compound growth, talk with your financial advisor and make sure you are putting time to work for you. You can also read my book, The Peace of Mind Investor, to discover other ways that time impacts your portfolio and investing options.