One idea I make clear to my students is that they will need to understand investing since in this new era, they will be responsible for their own retirement. A dwindling number of companies offer their employees a pension plan which will continue to pay them in retirement. I also like this question because it demonstrates the power of compound interest and consistently adding to your investments.
So, first have students estimate how much they need to save monthly over a 40 year period to have a future value of $1 million at the end of the period. Tell them to assume their stock market investments earn a return of 9.55% (which is the geometric average from 1928-2013 for the S&P500, according to data compiled by NYU) and that the amount they contribute every month remains constant.
Once they have each written down their guesses, you can project this investment calculator on the screen. You might start by putting some of your student guesses into the calculator before arriving at the correct number of $213:
To show the power of compound interest, you can ask the students how much they needed to contribute in order to create this future value over $1,000,000. Multiplying 480 payments by $213 equals $102,240. So in this case, the impact of compounding has almost a 10X multiplier effect: $102,240 was contributed to create a final future value over $1,000,000.
Two other points to extend this lesson:
- Demonstrate how sensitive the future value is to a change in investment return. There are no guarantees that the future returns of the stock market will equal the past. If you chose a more conservative return figure of 6%, that stream of monthly contributions of $213 for 480 months would only yield a future value of about $396,000. Important to highlight to students you cannot control the return you will get from the stock market, but you can control how much you save so be sure to have a buffer of safety by saving more.
- Don’t expect that $1,000,000 in future value to have the same purchasing power as $1,000,000 today due to inflation. In fact, assuming 3% inflation over the 40 year period means that $1,000,000 would be worth about $307,000 in today’s dollars (present value calculator here).