The power of compound growth in 401(k) plans

LAST REVIEWED Jan 29 2024
10 MIN READEditorial Policy

Key Takeaways

  • Compound growth can be a passive yet powerful way to help maximize your retirement savings.  

  • Compound growth occurs when you earn on the growth you’ve already earned, as well as your initial investment. 

  • Dollar-cost averaging (or regular, consistent contributions) can help investors make even more use of compound growth.

The sooner you start saving for retirement, the more you can take advantage of compound growth, which can be one of the most powerful tools for helping to grow your savings—and one of the easiest to use. In this article, we’ll define compound growth and explain how it could help make the difference between having some money saved and having even more money saved. 

What is compound growth?

Compound growth is a return that includes both the initial principal and the accumulated growth from previous periods. In other words, when there is a return on investments (be it savings or mutual funds) those returns are reinvested in the account and can then generate returns of their own. 

Think of it as money that can be earned on your original investment and on any growth you may earn on that original amount. It’s a double whammy: Your money (that’s the growth your initial investment may have earned) can earn more money (that’s the compound growth), just by sitting in the account! As always, it’s worth noting that investing is subject to risk, including the risk of loss, and there’s no guarantee that an investment will grow due to compounding.

How does compound growth work?

Compound growth is perhaps best explained through a particular type of compound growth: Compound interest. It’s helpful to understand how interest compounds to estimate how fast your money can grow. The more often your funds in the account are compounded, the more compound interest you’re likely to earn, and the more likely your money can grow. Conversely, the slower the interest on your debts is compounded, the slower your debt can grow.

Example: It’s perhaps easiest to see how compound interest can function in a hypothetical bank savings account. If you deposit $1,000 in a bank account paying 4% interest compounded daily and leave it there, without adding any further deposits, and assuming no fees are charged, at the end of 10 years, you should have $1,491.79.1

If you want to try the math, the formula for compounding growth is:

compound interest formula

Where P is the original or principal balance, r is the growth rate (as a decimal), n is the number of times growth is compounded in a specific time frame, and t is the time frame. However, if you’d rather have the internet do the math for you, try out these compound growth calculators:

Compound growth in mutual funds 

Compound growth in a mutual fund works the same way. But, because of fluctuations in stock and bond prices, mutual funds have a variable rate of return rather than a static interest rate. 

Example: A hypothetical mutual fund in a retirement account with an initial investment of $5,000 could become $40,582.49, assuming an average return of 7% compounded monthly over 30 years. If you added monthly contributions of $200, you could have $284,576.69 in 30 years time.2

Compounding growth and depositing earnings in an account may happen on different schedules. Bank savings accounts, for example, generally pay interest on a monthly basis, but a bank might compound it daily. That means that the bank calculates the interest earned on the account balance and the interest the account has earned that hasn’t been paid out yet. 

Keep in mind that compound growth returns are taxable unless the money is in a tax-sheltered account. Pre-tax earnings in a 401(k) are not taxable, for example, until the account owner retires and begins drawing money from the account.

Savings tactics: Start saving as soon as you can

If you’re trying to save money, we think it’s wise to take advantage of the potential for compound growth—and do it as soon as possible. Compound growth is often cited as a reason to contribute to your retirement funds as early as possible (and we believe investors should!). With the power of compound growth, a small amount of savings has the potential to build up meaningfully over time.

To help you understand the long-term potential impact of compound growth, let’s look at an example. The chart below demonstrates how a hypothetical $10,000 investment could have grown in the stock market over 30 years, from 1992 until 2022. In this example, we use the S&P 500 Index as a proxy for an actual investment in the stock market.

power-of-staying-invested

Past performance, including hypothetical performance, is no guarantee of future results. Investing is subject to risk, including the risk of loss. S&P data © 2023 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment; therefore, their performance does not reflect the expenses, or performance results, associated with an actual portfolio. Chart is for illustrative purposes only. See more information below.3

This chart does have its ups and downs, but these represent market fluctuations. You can see that if you had kept that money invested throughout this period, your $10,000 investment could have grown to over $173,000 by the end of 2022. If you got nervous during the 2009 financial crisis and decided to take all your money out of the market, your investment could have been worth only about $29,000 at that time. 

In other words, if you kept your hypothetical $10,000 in the market over that period, the compound growth could have accounted for $163,000, or 94%, of the $173,000 total you might have ended up with. As the adage goes, it’s not about timing the market, but time in the market.

Savings tactics: Small differences can grow over time

Compound growth means that even if you only sock away small amounts at a time, but you start early and do it regularly, you can end up with a meaningful nest egg. Compound growth can help to mitigate the risk of inflation and rising costs of living, which may otherwise reduce the purchasing power of your savings. 

Example: If you started with a hypothetical investment in a retirement account of $100 at the age of 25 and added $50 a month for 35 years, you could end up with $91,203 by the time you were 60 (assuming a 7% rate of return and monthly compounding).2

Savings tactics: Dollar cost averaging

Dollar-cost averaging (DCA) is another passive investing tactic that involves making regular and equal investments in an account that can add up to a meaningful nest egg by the time you retire. When you make regular contributions to your 401(k) via payroll deduction, you’re following this strategy. 

When you contribute to a Human Interest 401(k), that money is invested in mutual funds. The share price of most investments fluctuates daily, so each contribution buys a different number of shares—more when the share price is lower, and fewer when the share price is higher. One of the potential benefits of DCA is that you’re essentially spreading out the average price by purchasing at different times. This helps to mitigate the volatility of a given investment.

This “set it and forget it” method of investing—regular contributions to an investment account that you hold, regardless of share prices or economic outlook—seeks to mitigate your investments against market fluctuations. To be clear, DCA does not guarantee that your investments won’t lose money, rather, it means that by regularly contributing and staying in the market, you don’t miss out on market highs and lows. Consider your ability to continue investing in down markets. Dollar Cost Averaging does not ensure a profit or protect from loss. Investing involves risk, including risk of loss. Ultimately, the goal of dollar-cost averaging is to allow investors to spend more time in the market without worrying about timing the market.

The bottom line: Start early and save often

We believe that combining the power of potential compound growth and dollar-cost averaging by automatically contributing to a retirement account is a smart, and simple way of saving for retirement. Whether you’re new to building a nest egg or nearing retirement age, it’s never too late to open a retirement savings account and help maximize your retirement savings.

At Human Interest, we provide affordable 401(k) plans for small to medium-sized businesses and offer free educational tools to help savers prepare for retirement. Sign up for our newsletter below to learn more.

As Investment Director for Human Interest Advisors (HIA), Ronnie’s responsibilities include market and economic commentary, analytical tooling and reporting oversight, and the investment manager search, selection, and monitoring processes. He chairs HIA’s Investment Committee, which sets strategic policy and direction of HIA's investment services.

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Notes

1

Human Interest calculations. For informational purposes only. Does not represent an actual savings account and the interest rate is not guaranteed.

2

Human Interest calculations. For informational purposes only. Ending values do not reflect the effects of taxes, asset fees, market fluctuation, or investment expenses; if they did, results will be lower. Earnings and pre-tax contributions are subject to taxes when withdrawn. Distributions before the age of 59 1⁄2 may also be subject to a 10% IRS penalty. Does not reflect the impact of market fluctuation, the performance of any Human Interest account or any actual investment. There is no guarantee that the assumed rate of return will be achieved or that any systematic investing plan will be successful. Actual results will vary. Investing is subject to risk, including the risk of loss. 

3

If you invested $10,000 in the S&P 500 at the beginning of 1992, you could have had about $25,392.04 at the end of February, 2009 assuming you reinvested all dividends. Hypothetically, this represents a return on investment of 188.57%, or 6.43% per year. This Dataset simulates an individual investing $10,000 in the S&P 500 at the beginning of 1992, which could have grown to $115,731.97 at the end of March, 2020, assuming that individual reinvested all dividends. Hypothetically, this represents a return on investment of 1,057.32%, or 9.40% per year. This Dataset simulates an individual investing $10,000 in the S&P 500 at the beginning of 1992, which could have grown to $173,182.25 at the end of 2022, assuming that individual reinvested all dividends. Hypothetically, this represents a return on investment of 1,631.82%, or 9.97% per year. This chart includes the full dataset pertaining to the 372-month period between 1992 and 2022, including gains and losses. Dataset shows the monthly average closing price. Returns include dividends and are based on the average closing price across the entire month. Some losses are offset by dividend returns. Dataset is provided by Official Data, a website based in San Mateo, California, that seeks to collect and process government data for the benefit of the public, and is derived from Robert Shiller's book, Irrational Exuberance, and the accompanying dataset, as well as the U.S. Bureau of Labor Statistics' monthly CPI logs. Inflation data used is based on annual CPI averages. Shows the full dataset pertaining to a $10,000 investment, including gains and losses, over the 372-month period between 1992 and 2022. Past performance, including hypothetical performance, is no guarantee of future results.