BLOG: The first pounds are the cheapest: The power of compounding

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30/10/2014
The Government's auto-enrolment scheme now covers all firms with at least 60 employees and has made significant inroads into getting younger savers into useful habits which will help their overall retirement fund.

For many, however, the notion of saving for a pension at a young age feels tough at a time when many are looking to get on the property ladder, paying high rental costs, or clearing their student loan. However, where there is some money to spare, even small pension contributions made over a long period of time can make a significant difference to your retirement fund – much more than trying to create a pension in its entirety later in life. Whilst hard pressed individuals will rightly have a priority of paying down expensive debt it will be important not to miss out on any contributions that their employer will make on their behalf if they agree to make payments themselves.

For example, a 30 year old who saves five per cent of their £40,000 annual income over the remaining 35 years that they work would have a pension fund of £153,196.63 when they retire at 65. This is largely due to the power of compound interest (in this example the fund grows at a modest four per cent each year). Here, the employee does not ever make greater contributions annually to his pension fund than the £2,000 he pays in from the first year – in reality you would expect to make greater contributions as your salary rises.

In contrast, a 50 year old who has spent their career to date focusing on other financial priorities – such as buying a property and paying off their mortgage – before realising they need to play ‘catch-up’ on their pension savings. As a result, they put 15 per cent of their £40,000 annual income straight into a retirement fund for the next 15 years. Despite this larger contribution, they would only have £124,947.19 at age 65 (again assuming modest investment returns of four per cent annually).

It goes without saying that the more you save over your working lifetime, the better, and many would hope to have an eventual retirement fund far in excess of £150,000. But remember, the first pounds you save are the ones that will work hardest for you. Even if you cannot contribute as much as you might like, the power of compounding shows that it is vital to put something into your retirement fund as early in your career as possible.

Compound calculations from: http://monevator.com/compound-interest-calculator/

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