The Rule of 72 and Retirement Planning
The Rule of 72 is a quick and easy mental shortcut to help you estimate the number of years required to double your money at a given compounding annual rate of return or interest rate. It's a great way to help you determine how various investment strategies and risk tolerances fit in with your specific retirement goals.
The rule states that you divide the rate, expressed as a percentage, into 72:
72 ÷ annual rate of return = number of years it will take to double investment
For example, an investment with a 6% compound annual rate of return will take 12 years to double in value.
72 ÷ 6 (rate of return) = 12
Make sure to enter the rate of return as a whole number (i.e. 6) rather than as a decimal (0.06).
The Rule of 72 calculation can also be used in reverse, to estimate the average annual rate of return needed to double your money over a specific time period. In this scenario, you use the following equation:
72 ÷ number of years = annual rate of return to double an investment
For example, if you want to estimate the annual rate of return needed to double your money in 10 years, you simply divide 72 by 10. So the answer is a 7.2% annual return:
72 ÷ 10 (desired number of years to double the investment) = 7.2%
The Force of Compounding Interest
The Rule of 72 illustrates just how important compound interest can be when it comes to investing. Albert Einstein described compound interest as “the most powerful force in the universe.” And it can indeed be powerful in the world of retirement planning.
In the simplest of terms, compounding interest means earning interest on interest. This means that each and every time interest is paid, it is paid on an increasingly larger and larger amount that includes the previous interest earned.
Here is a straightforward example. Earning 5% interest on $1,000 would result in $50 of interest per year. But with compounding, it would actually be $50 the first year, $52.50 the second year (5% of $1,050), $55.13 the third year (5% of $1,102.50), etc.
There are five main components that impact the power of compound interest or returns in a retirement fund: the interest rate or rate of return, how frequently it is to be compounded (monthly, quarterly, annually, etc.), the amount and frequency of any additional investments, and how long the account is allowed to compound.
Time is one of the most important factors because it allows you to accumulate serious money on relatively small investments. You’ve likely heard the phrase that “time is money.” With compounding interest, the more time you have on your side, the greater your retirement savings.
Using the Rule of 72 in Retirement Planning
The Rule of 72 is a great way to quickly boil down whether your investments are going to prepare you for retirement when and how you need them to.
For example, if you have selected a relatively safe option in your 401(k) plan, such as a stable value fund that is currently earning 3% annually, it will take 24 years for your money to double (72 ÷ 3 = 24).
Ask yourself if that's fast enough (and take into consideration your ability to make increasingly higher contributions to the fund too.) If it's not, a less conservative approach would be to invest in a mix of funds whose average annual return is 6%. In that case, it would take only 12 years (72 ÷ 6) for your money to double.