You’ll often hear financial experts extol the virtues of saving early and often for your retirement. But what you might not be aware of is the magic of compound growth, described by Albert Einstein no less as the ‘eighth wonder of the world’.
‘He who understands it, earns it,’ said the father of the theory of relativity. ‘He who doesn’t…pays it.’
But what exactly is compound growth? And how can you, as an investor, harness it to boost the value of your pension pot?
How does compound interest work?
Fortunately, you don’t have to be an Einstein to understand how compound growth works. Let’s take a simple example – we have two investors, Jack and Jill, both basic rate taxpayers who make a net pension lump sum contribution of £1,000 per year (when 20% tax relief is added on, that means a gross amount of £1,200 is invested).
For the sake of this simple illustration, let’s also assume both enjoy investment growth of 5% a year after charges (the FTSE All-Share has returned around 6% per year over the past 20 years).
Jack started saving at age 18 but then stopped at age 30. Even though he stops saving, the pot remains invested and continues to grow, leaving him with a pension pot worth £134,468 when he reaches age 68.
Jill, on the other hand, put off saving until age 30 – and the power of compound interest means she will need to keep paying in until age 67 before she has the same sized pension pot as Jack. In sum, Jill has had to pay in an extra £14,000 over 37 years to get the same sized pension as Jack, who saved the same amount per month for just 12 years.
The reason for this disparity is compound growth. Because Jack started saving earlier than Jill, his money had more time to increase in value. And because each month he tops up his pot, each year its real value increases by more (because 5% of a bigger number is a bigger number).
So in year one his £1,200 increased in value by 5% to £1,260 – that’s £60 added through investment growth. But in year two his £1,200 is added to his £1,260, giving a total of £2,460. That amount is increased by 5% to give £2,583 – an extra £123 added to the value of his pot. And so on.
In order to maximise the benefit of compound growth, you need to do two things – save as much as you can as early as you can, and expose your pension to at least some stock market risk.
The extent to which you can do this will depend on your age and your attitude to risk. The value of your investments can down as well as up, so you’ll likely be more able to stomach the volatility of the stock market if you’re younger (and thus further away from drawing on your pension).
Above all, compound growth emphasises the importance of putting money aside for your retirement early and often. Ultimately it means if you contribute to a pension sooner rather than later, you will have a significant advantage over those who put off saving.