The Rule of 72 and Retirement
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. The rule states that you divide the rate, expressed as a percentage, into 72:
The estimated number of years it will take to double investment = 72 ÷ annual rate of return
For example, an investment with a 6 percent compound annual rate of return will take 12 years to double in value.
72 ÷ 6 (rate of return) = 12 (estimated number of years it will take to double an investment)
It is important 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 to estimate the average annual rate of return needed to double your money over a specific time period. To estimate the required rate of return using the Rule of 72, you can use the following equation:
The estimated compound annual rate of return to double an investment = 72 ÷ number of years
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.
72 ÷ 10 (desired number of years to double the investment) = 7.2 (estimated compounding annual return)
The Force of Compounding Interest
Albert Einstein described compound interest as “the most powerful force in the universe.” It can indeed be a powerful force 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 percent 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.
Applying the Rule of 72 to Retirement Planning
The Rule of 72 can help you determine how various investment strategies and risk tolerances fit in with your specific retirement goals.
For example, if you have selected a safer option in your 401(k) plan, such as a stable value fund, that is currently earning 3 percent annually, it will take 24 years for your money to double (72 ÷ 3 = 24). You should consider whether that's a fast enough doubling for your retirement needs while also taking into consideration your ability to make increasingly higher contributions to the fund.
A less conservative approach would be to invest in a mix of funds whose average annual return is 6 percent. In that case, it would take only 12 years for the money to double.