Pensions savings seem to be all the fuss of late. Many people in their 40’s and 50’s have come to realise that they have just not saved enough and will have to put off retirement for a few years in order to work and save more. Even though these people are socking away thousands a month into their retirement accounts, they have found that it is not enough. The biggest reason for this is they did not start early enough. They have not let time do the hard work by compounding their returns.
Did you know that those who save for just 10 years, between the ages of 25 and 34, will have a higher savings pot than those who save for 30 years between ages 35 and 65? What is it that makes this unintuitive statement true? The answer is the compounding effect.
Compound Interest is a very powerful concept when it comes to investing. It is interest that is accumulated on investment and then added on to the original investment so that the accumulated interest can also earn interest. This results in a much larger growth than could be achieved with the interest on the original investment alone.
A study conducted by Credit Lyonnais Securities Asia (CLSA) demonstrates the importance of the effects of compound interest when investing money for retirement. The study compares two investors who save £2,500 per year for retirement and invest in a fund with an average annual return of 7%.
- Investor A has only saved for 10 years between the ages of 25 and 34 and then left his investment untouched in the fund until he reached retirement at the age of 65. At retirement, the £25,000 (£2,500 for 10 years) he contributed to his investment fund has compounded to a total of about £281,000.
- Investor B on the other hand has also paid £2,500 per year into the fund, but has done so over a period of 30 years – starting at the age of 35 and ending at 65. At retirement, the £75,000 (£2,500 for 30 years) he contributed to his investment fund has compounded to a total of about £255,000.
As can be seen from the above, Investor B has contributed more to his pension fund but has ended up with less! This is astounding considering investor B put £50,000 more into his fund. This just goes to show the power of time and compounding when it comes to investment returns. The lesson from this is that when starting to save for retirement, you need to do so early in life in order to get the highest possible pension pot.
The best time to start saving is in your 20s. This is when you get your first job but are not yet tied down to adult responsibilities like paying for a mortgage or looking after a family. I for one have been lucky enough to realise the power of compounding at an early age and this has allowed me to live frugally and throw every penny of spare cash towards buying money generating assets whilst still in my 20s.
But even if you missed the opportunity to start saving in your twenties, you can still profit from an investment in the capital markets. Investing your savings during the 10 years between the age of 31 and 40 is still worth more than saving and investing the same annual sum over the next 30 years.
There is a very clear link between saving early and wealth creation. So start saving and investing early and don’t leave your retirement income to chance!