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retirement planning

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High-school students preparing for graduation may be thinking about what to wear to prom, what to study in first-year university, or what to pack when they leave home.

Preparing for retirement? What? Not on their minds.

But financial experts say it should be. While retirement may be a hazy concept to most secondary-school graduates, saving for it early will give them a leg up once they stop working decades down the road.

Compound interest – even in an era of low interest rates – will work in their favour.

David Baskin, president of Toronto's Baskin Wealth Management, recommends starting to save for retirement at age 18.

"Because of tax-free savings accounts (TFSAs), the value of starting at 18 with $10,000 a year or less is extraordinary because they'll have so many years of compounding. People talk about compounding as magic, and it really is, particularly when you have a very long period of time, like 45 years."

In very basic terms, compound interest can be thought of as interest on interest. It's defined as interest that's calculated on the initial principal as well as on the accumulated interest of previous periods of a deposit, making it grow at a faster rate than simple interest.

A single contribution of $10,000 into a TFSA at age 18 becomes more than $257,000 by age 65, assuming a seven-per-cent return during that period.

"That's compounding," Mr. Baskin says. "It doubles every 11 years, and when you start that early you've got a lot of doubles. That's the trick.

"If you were able to put $10,000 a year in [a TFSA] every year from age of 18, you'd have $3.8-million by 65," he adds. "It's enormously powerful. Especially if there's no tax involved, it's not to be avoided."

Even at an interest rate of 5 per cent, the growth would still be impressive: a deposit of $10,000 would become $104,000 by age 65; put in $10,000 every year until retirement and you'll have more than $1,974,000.

Albert Einstein, in fact, described compounding as the greatest mathematical discovery of all time. "Compound interest is the eighth wonder of the world," the genius is quoted as saying. "He who understands it, earns it. He who doesn't, pays it."

Personal-finance expert Kelly Keehn says it can be hard for young people to get their heads around the concept of compounding. "We're not using cash and we're tapping with our phones to make purchases."

But she says compound interest can make or break your opportunity to buy a house or to retire without debt.

"We have to be very aware of compound interest, whether we're talking about investing or, on the other side, debt," says Ms. Keehn, a member of the Financial Consumer Agency of Canada's national steering committee on financial literacy and author of nine books, including Protecting You & Your Money: A Guide to Avoiding Identity Theft & Fraud.

She has a point: Just as compounding does miraculous things when a chunk of money is put away early, it also adds up very quickly when you use a credit card for a big purchase and then make only the minimum payments.

"You might look at a sofa and throw it on a credit card, but let's say you're using a department store credit card and the interest is 29 per cent," Ms. Keehn says. "That impulse buy of $800 is going to cost you $2,000. If you knew that, I bet you wouldn't have bought it.

"I did this in my 20s with my first credit card," she adds. "I had a $2,500 limit and thought, 'Yeehaw!' But I started looking around at all my stuff. I sat down and calculated with compound interest what this stuff was costing me, and I was ready to vomit."

The power of compound interest may be easier to grasp when you see how it helps you chip away at a large debt, such as a mortgage, rather than the notion of it accumulating into a much larger amount by saving over time.

Because young people have the greatest advantage when it comes to compounding, securing a comfortable retirement may seem more out of reach for those who are already halfway there and who haven't been saving. However, financial advisers say it's never too late to start.

"If you're not lucky enough to have started early, you don't get those years of compounding … you have to be smarter and probably more aggressive," Mr. Baskin says. "There is still a widespread misbelief out there, probably fostered by the banks, that TFSAs in particular should be nothing but savings accounts and you should buy GICs or similar low-yield instruments.

"A five-year GIC is around 2.5 per cent," he notes. "If you're 50 years old looking to retire in 15 years, 2.5 per cent is not going to do the trick. The shorter the period of time you have, the more aggressive you have to be about making higher returns. Right now that means you must own stocks in order to make up for the low-yield world."

To make up for lost time, it's also vital to understand the relationship between TFSAs and registered retirement savings plans (RRSPs), and when to use each one.

"If you're in your 40s and haven't invested in anything, if you have a good income and you've paid off debt so you have no car loan or student loan, you can start to carve out unused room in your RRSP," Ms. Keehn says. "Canadians are really great at paying debt, but they're not great at saving. It's not for everybody, but it may make sense to take a loan out and throw money at that unused room in the RRSP, using the tax deduction to pay down the loan."

RRSPs are best used by people in high tax brackets as opposed to 18-year-olds working low-paying jobs who would do better with a TFSA. People need to learn more about using both vehicles and orchestrating the timing of them, which is why Ms. Keehn suggests seeking unbiased financial advice.

"A lot of people still don't understand what an RRSP is and if it's right for them," Ms. Keehn says. "At key points in their life, people should go to a fee-only certified financial planner. It's very important to sit down with someone who isn't selling you anything at least once every five or 10 years to go over a financial plan."

As for those who are starting late when it comes to saving for retirement, Mr. Baskin sums up his advice this way: "Make sure you take maximum advantage of what the government is giving you," he says. "It's a low-return, high-tax world, so if the government is giving you a present, make sure you use it."

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