What Is Cash For Life and Compound Interest?
Today, I am here to tell you about cash for life or as commonly referred to in the pension world – annuities. If you are approaching retirement you know that accumulating funds are only one side of the story making these funds last for the balance of your life completes the tale. The decision of where or how to access your retirement funds can be difficult, considering all the information you need to sift through. Your choice may be influenced by the health of you and your spouse, your ability to deal with market fluctuations, financial obligations, and the amount of time you are willing to spend managing your financial affairs.
Often we are told that consolidating funds or “putting all your eggs in one basket” at retirement is the preferred approach. However, maintaining safety and growth so retirement funds last for your life time are extremely important. A recent Globe and Mail article by Rob Carrick suggested how annuities or cash- for-life options are an important retirement planning tool to consider. At a time of longer life spans, it would seem that the cash-for-life or annuity option makes sense, but people are often hesitant to select this option due to the low rates of return. Carrick’s argument is that “The certainty and security of cash for life are worth giving up some returns.”
By choosing an annuity, it will be like receiving a monthly pay cheque guaranteed for your lifetime. You will have the peace of mind knowing that you have no further investment decisions and your monthly income won’t change or stop. Depending on which annuity you choose, some will pay benefits to your beneficiaries in the event you die earlier than expected. However, everyone should plan for a long life, a good retirement and funds to go along with it.
In Saskatchewan, there’s often concern about how things are growing, whether it’s our economy, our population, or on a more local level, our crops and livestock. We want to see growth. At Saskatchewan Pension Plan we are concerned about the growth of our members’ investments. A key principle that contributes the growth of member accounts is compound interest. Today we want to explain this in principle and illustrate its power over your money. Simply put, compound interest can be thought of as interest on interest. This means that interest is calculated on the initial investment and also on the accumulated interest of previous periods. The rate at which interest accrues depends on the number of compounding periods. If interest compounds annually the investment will grow much slower than if interest compounded monthly or daily.
Let’s illustrate with an example: Starting with $2,500 invested annually for 30 years at an average annual return of 8%. This first illustration shows the value at the end of 30 years when the interest is compounded annually. Now, let’s look at the same example, the only this time the compound incurs monthly as the case is at SPP. Compounding interest monthly results in a higher effective rate of return. Your effective rate of return will actually be 8.3% as a result of compounding monthly, in comparison to the 8% annually. You can see why Albert Einstein is supposed to have considered compound interest one of the Wonders of the World. Compound interest is the eighth Wonder of the World He who understands it earns it he who doesn’t pay is it the longer your time horizon the greater benefit you realize from the magic of compounding.