A common reaction among my peers to the slow-motion car-crash that is the pensions crisis is: “We’re gonna have to work ’til we’re dead anyway.”
It’s a fatalistic, short-sighted, shoulder-shrugging attitude that translates as: “I’m not saving enough for my pension and I’m going to put off doing anything about it by pretending I can’t do anything about it.”
But of course there’s plenty we can do about it, and it only takes a quick play with a compound interest calculator to see that delay does nothing but make the problem worse.
Compound interest and time are the nitro and glycerin of personal finance. Except it’s a friendly explosion.
It’s well known that compound interest can turbo-boost your fortune. Initially the effect of earning interest on interest is small – almost invisible – but over time it accelerates dramatically.
To maximize the miracle grow power of compound interest, it’s important to understand the major components that influence the effect:
- Time: The longer you can wait before you spend the money, the bigger the snowball effect of compounding.
- Interest rate: A small difference in the amount you earn makes a big difference over the long term.
- Tax and other costs: The less tax is clipped off your interest (or the longer you can defer the day of reckoning with the taxman) the more your returns will have had a chance to compound.
- Frequency of compounding: The more often interest is paid (such as quarterly or monthly), the quicker the compounding effect can get to work.
Time is the critical factor
Compound interest can do much of the heavy lifting towards your financial goals, if given enough time.
- If you harness the power of compound interest from age 20 then you only need to save £2,581 per year to hit the target, assuming an annual average interest rate of 8%.
- A 30-year old who starts saving at the same rate ends up with less than half the amount by 65: £480,329.
- A 40-year old is left wondering where all the time went, getting only a fifth of the way to a million by 65: £203,781.
Here’s how much our 20-, 30- and 40-somethings would have to put away every year to earn a million at 65:
|Amount saved p.a.
The differences are horrendous. Delay for 10 years and you must save at over twice the rate. Wait 20 years and you’re looking at saving more than five times the amount of a 20-year old.
Make your child a millionaire: If you’re expecting kids any time soon, you could make your child a millionaire by age 65 by unleashing the power of compound interest. Start investing for your kids from day one and if you earn an average annual interest rate of 8%, then tucking away just £1.48 a day will do the trick. Not a bad present in these days of pension insecurity. Just make sure they can’t get their mitts on the moolah a day earlier!
The interest rate matters
Seemingly small changes in the interest rate can have a profound impact on your final result. See how much less our protagonists need to save if we up the average annual interest rate to 10%.
|Amount saved p.a.
Our 20-year old would-be-millionaire can save nearly 50% less per year by earning 2% more than in our previous example.
Stretching for yield works less well (and is considerably more dangerous) for the 40-year old, who can only reduce his annual saving amounts by around 25%, given the shorter time he has left.
Don’t sell yourself short
In contrast, things look considerably less sunny if we drop the average annual interest rate to 6%.
|Amount saved p.a.
A 20-something investor earning 6% must save 81% more than a 20-something who earns 8%. With less interest to compound over the decades our young investor must increase their annual commitment, if they want to achieve the same financial goal in the same amount of time on the lower interest rate.
Meanwhile, our tardy 40-year old must find an extra 33% at 6%, in comparison to 8%.
The message is that it can pay to invest aggressively if you’re young and you can handle the risk. Sitting in low-yielding assets like cash or bonds is likely to cost you over the long run.
The historical return rate of the UK stock market is around 5% before inflation (add on about another 3% for that) while cash and gilts have brought in about 1%.
If you’re young then you have the time to hopefully take advantage of the peaks and ride out the troughs that come with an aggressive asset allocation tilted towards equities.
The table above also shows why you must guard against other assailants trying to mug your returns, such as the taxman and the expensive fund manager.
Make sure your money is tax-shielded in ISAs and pensions, and that you use low-cost index trackers so that the power of compounding has as much interest, dividends and capital gain to work with as possible.
- Don’t think that investing for the future can wait until later. The early years count. Start saving something now and do it regularly. The longer your investments have time to grow, the greater the power of compound interest to make you money.
- Be patient and think long term. Leave the money alone. Reinvest all your gains. The effect of compounding is miniscule at first and may seem agonisingly pointless. The most dramatic effects occur in the later years, but you’ll be grateful for them and will thank your younger self for your foresight.
- It’s never too late. You may have lost years to procrastination, financial naivety or whatever else – I know I did. But here’s a brilliant quote about letting go of the past:
The best time to plant a tree is 20 years ago. The second best time is now.
Forget about yesterday, and do something about tomorrow.
Take it steady,
- I’m not saying you need a pension of a million pounds. I’m simply using the figure to illustrate that compound interest can make the seemingly unachievable achievable. [↩]