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How compound interest can save our pensions

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.

How regular contributions are transformed by compound interest

Compound interest’s most spectacular effects occur in later years.

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.

The Monevator millionaire calculator illustrates the point by showing how much you need to save every year to earn a million by age 65.1

  • 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:

Age Amount saved p.a. Interest rate
20 £2,581 8%
30 £5,770 8%
40 £13,494 8%

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%.

Age Amount saved p.a. Interest rate
20 £1,389 10%
30 £3,676 10%
40 £10,066 10%

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%.

Age Amount saved p.a. Interest rate
20 £4,679 6%
30 £8,894 6%
40 £17,900 6%

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.

The takeaways

  • 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,

The Accumulator

  1. 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. []
{ 30 comments… add one }
  • 1 Simon December 27, 2011, 1:22 pm

    It’s holiday time and I have some time on my hands so a more realistic example based on saving what can be afforded each year (relative to salary) rather than a fixed amount each year…

    20 years old Financial-Warrior.
    Earns £20,000 per year.
    Invests 15% of their gross income in tax sheltered accounts every year.
    Gets a 2% real wage rise every year (so they are earning £29,719 p/a by age 40 in todays money).
    Manage to get 6% interest on investments every year AFTER inflation and fees.

    Nest egg at retirement, aged 66, in today’s money: £1,027,091.
    Final year’s salary will be £49,732 p/a.
    Withdrawing 4% of nest egg each year of retirement gives £41,116 p/a or 83% of final salary.

    Relatively low salaries and conservate assumpions (?) means nice retirement.

    Now same for Johhny-Come-Lately who is a higher earner but doesn’t start until 40:
    Earns £60,000 per year. (More than double Finacial Warrior at same age).
    Invests 15% of their gross take home in tax sheltered accounts every year.
    Gets a 2% real wage rise every year.
    Manages to get 6% interest on investments every year AFTER inflation and fees.

    Nest egg at retirement, aged 66, in today’s money: £743,037.
    Final year salary £100,405 p/a.
    Withdrawing 4% of nest egg each year of retirement gives £29,721 p/a or 30% of final salary.

    Financial-Warrior has lived a (relatively) frugal live from age twenty and so, in retirement he feels REALLY rich while Johhny-Come-Lately still gets MORE than the current average UK salary in retirement but feels REALLY poor compared to when he was working.

    Is the moral that only Financial-Warrior has any hope? Not at all!! He’s much brighter than I’ll ever be and will have a fantastic retirement and probably have significant money to pass on to his relatives when he dies. The moral is that Johhny-Come-Lately will have NOTHING unless he starts today 🙂

  • 2 ermine December 28, 2011, 1:16 pm

    I couldn’t resist it, I had to come up with a post “how I got away with not saving for a pension in my 20s” inspired by this and the previous article. I’m even greedy enough to want to retire before 60 and on track to do it 🙂

    First, I’m not saying you shouldn’t save in your 20s. There is a case to be made for using other vehicles than a pension and taking a whole systems view of your finances (buying a house and owning it outright saves you rent when you are retired as long as you pay it down by then, f’rinstance) You probably should be saving somewhere at the NEST 8% rate.

    From the other end of the telescope, there are some things that make it so much easier to catch up later. If you experience any career progression at all in real terms you punch way over your 20-year old self’s weight. I have saved 2* my gross salary in the last 3 years. To save the same in real terms at the beginning of my career, that would have taken me 7 years, plus my outgoings were a higher proportion of my salary so it would have been harder.

    Austerity is easier when you are an old git that when you are young. Two years of my gross, when I am earning over twice the amount in real terms as in my youth, is equivalent to 24 years NEST saving at 8% from 20. Okay, so compound interest roughly doubles your 20 year-old’s savings after 30 years, so it’s equivalent to about 12 years in NEST with compound interest over 30 years.

    This issue is a lot more complex because of the very low capital base young people start from, and the possibilities of career progression. Perhaps I was unusual in achieving 2.3x real terms career progression from my first proper job, and perhaps that won’t be easy to come by in future. All I’m saying is that Johnny-come-latelys may have some serious advantages which you aren’t factoring in. I’m one of those slow starters (I started at 28), I’m living it, and I’ve got track record to prove it 😉

    So yes, save early for sure, and for God’s sake avoid debt for consumer items and anything other than assets. But take a whole-life viewpoint. Saving into a pension which is 50 years away is a difficult call compared to other savings like ISAs. Young people are unlikely to benefit from some of the good things about pension tax treatment, like saving 40% going in and paying 20% coming out, and they may have assets other than a pension that may be worth prioritising higher at this remote stage. Agreed they need to have started in earnest at 30 (40 years away from drawing the pension)

  • 3 Ash December 28, 2011, 2:40 pm

    All of this information is clearly true but it all rests on the assumption that you can beat inflation by 4/6/8%. At present this doesn’t appear to be possible, even investing in risky stocks etc is no guarantee that you will beat the market.

    Are people assuming that the gains experienced by stockmarkets in the 20th century, but so far not seen in the 21st are going to return and all the shares we are buying now are cheap?

    I’ve been investing in trackers since I was 25 (only 28 now) and my returns have been unimpressive. Then again we have been going through something of a credit crunch/sovereign debt crisis so perhaps things will improve.

  • 4 ermine December 28, 2011, 3:46 pm

    Ash, you’ve been investing in the most hellacious downturn I have experienced, barring the 1970s when I was at school. The good news is that you’ve been buying when the FTSE100 has been cheaper on a P/E basis than it has been for a while. You have thirty-ish years for your purchases to come good, and it’s very likely they will!

  • 5 Paul December 29, 2011, 11:14 am

    Ash, the best time to invest is during a downturn. It always takes more nerve, it easier to invest into a rising market, but it pays off better. You may have a few rocky years but the upturn will take your investments to +6% (real annualized), probably well above. Don’t chase early returns by stock-picking……your tracker strategy is exactly right.

  • 6 Simon December 29, 2011, 1:27 pm

    @ermine – I completely agree that it’s never too late. I’m 45 and currently at 4.5x my salary at age 20. So it’s a MUCH easier to save now. When I was 20 a very wise person advised me to put aside 10% of every salary cheque into a pension. I signed up exactly that amount and then never changed my direct debit for 20 years!! Disaster!! Like you I’m living the life now but how I wish I had really understood what I was told when I was 20 🙂 On the other hand I’m still better off than if I’d done nothing until I was 40.

    @Ash – I couldn’t agree more with the comments of ermine and paul. However be aware that there are no guarantees. You are giving yourself a great chance for it to all work out and your timing is looking good. In the unlikely, but possible, event that your money loses value in real terms over the whole of your working life you will still have a very significant amount of money set aside. If the economy bombs out that much for that long then your “smaller” nest egg will lift you WAY above the general population (who will be up a smelly valley without any means of propulsion at that point!)

  • 7 Paul December 29, 2011, 5:33 pm

    I agree there are no guarantees but I think the chance of a lifetime of negative markets is vanishingly small. Using the best available long-term stock market data (Shiller’s data on the US market) the current valuation is below trend. The longest losing spell (real terms, dividends reinvested) for stock bought below trend is 8 years, and that period included a World War! That does not include expenses and taxes but I think it improves the perspective.
    What a pleasant blog this is. All the best for 2012 to you all.

  • 8 Tim December 30, 2011, 3:33 pm

    Nice to see all the optimists here. If anyone can tell me how to get 8% in real terms after fees, year after year then they can manage my money for me. The best return you can get at the moment is negative in real terms and I doubt theres many of you that have made anything near 6% in real or nominal terms so far this century. Im sorry to throw cold water on you all but things are not as they were. Plus theres no guarantee that things are going to get better just because they have been bad for so long.
    The only sure thing you can do is spend less everything else is pure speculation. I’m delighted that some of you are able to actually save anything at all.
    @Paul I disagree with your premise that a lifetime of negative markets is “vanishingly small” perpetual growth in particular at the rapidity we have seen it since the industrial revolution is rare and ultimately unsustainable given the finite resources we have , which already are under extreme stress. Now Im not saying we’re all doomed but its more than a tiny possibility. You might want to think about some strategies to deal with that possibility

  • 9 gadgetmind January 1, 2012, 4:09 pm

    A portfolio of 80% equities and 20% bonds should give a long-term real return (after inflation) of 4% pa as long as dividends are re-invested. Of course, such a portfolio can steadfastly refuse to do this for long periods of time, but it should then play catch up for a while.

    Low fees, dividend reinvestment, drip-feeding, a balanced portfolio, and several decades are all essential elements.

  • 10 The Accumulator January 3, 2012, 9:20 pm

    I seemed to have even less time during the holidays than ever, so only getting to this now.

    @ Simon – thanks for taking the time. Very interesting examples.

    @ Ermine – glad I’ve managed to inspire you. You seem to interpret every article about compound interest as an attempt to crush the hopes of anyone over the age of 25. We obviously both know that’s not the case, the point is to show the power of compound interest not to claim you’ll live in poverty if you’re not saving your paper round money. I’m a late starter myself so I certainly haven’t given up hope, but am determined to take advantage of the time left on the clock. In other words, I couldn’t start a moment too soon.
    To save twice my gross salary in 3 years – I’d have to live on air. After tax that would mean I’d have to save 100% of net salary.

    @ Ash – the historical return of the UK stock market is 5% after inflation, so 8% doesn’t seem unreasonable, assuming inflation at 3%.

    @ Tim – same again. And that period includes two World Wars, the loss of Empire and everything else the Twentieth Century could throw at us. You may be right, things may never be the same again, it could have been a blip, but on the other hand like Malthus you could be wrong. This is a long-term game, it’s not about prophesying doom because we’re in a trough

  • 11 Tim January 3, 2012, 9:59 pm

    8% after inflation is away with the fairies. I started investing in 1998 when the FtSe100 was 6200 it’s now 5600. Of course I could be wrong but I think it’s dangerous to assume such a high return and there’s a reasonable risk that you could be down after 20 years. Compound interest is great if your timing is lucky and you don’t need the savings in reality very few people can do it they simply don’t have long enough saving periods in their lifetimes plus you always have to offset frugal living with err…. living…. after all you never know how long you’ve got Best advice to give young people is to avoid the worst investments don’t think you’re a genius when you get lucky and always fear the worst and if it looks too good to be true then its a con. Oh and avoid fees as much as you can…

  • 12 The Accumulator January 3, 2012, 10:35 pm

    That’s 8% with inflation. Not after.

    Compound interest is great if you’ve saved for 10 years, 20 years, whatever… It’s more powerful if the rate of interest is higher and if you save for longer. The effect is amplified the longer you can wait. It’s worth knowing about and using to your best advantage.

    The degree you benefit is variable of course, and it’s not the answer to all our problems but it’s a powerful incentive to get going and not keep assuming that it’ll be ok if I put off saving for another day. Because one day it’s just too late. There’s a reasonably small risk you’ll be down after 20 years, with a diversified portfolio, but it certainly can happen. That’s another good argument for getting started sooner rather than later – the longer you’re invested, the more likely you’ll have ridden enough peaks to go with your troughs.

    As for frugal living, I’d be living less frugally now if I’d lived a bit more frugally earlier.

  • 13 Ben January 4, 2012, 12:48 pm


    very interested in the concept of pensions for babies, 65 years of compounding could prove immense. I think I may start one up. Its a ridiculous way into the future but I was thinking that if my folks had done that it would have been quite a good thing – e.g. it would take a bit of pressure off what I have to save now

    Has anyone else gone down this route? – maybe others have good reasons why it might be an unwise thing to do?

  • 14 gadgetmind January 4, 2012, 12:59 pm

    @ben – My daughter is still at school and has a stakeholder with Aviva opened via Cavendish Online. 0.55% AMC, which isn’t bad.

    We don’t put in much, but you can go up to £240pcm, which gets grossed up to £300 by HMG.

    Some of her school friends have had pensions since age 2!

  • 15 Ben January 4, 2012, 2:47 pm


    I’d prob go with SIPP, what benefit do you get from Aviva s offering over doing it yourself?

  • 16 gadgetmind January 4, 2012, 2:59 pm

    @ben – we’re only putting £25pcm in at the moment, and it was going to be hard to drip-feed that into anything obvious, however, I’d love to know what you find.

  • 17 Matthew January 20, 2012, 8:28 pm

    Rememeber that the following companies have dividend yeilds of over 6%. (Man Group is 11%) If they don’t go anywhere in 10 years, you still make 6%.


  • 18 gadgetmind January 20, 2012, 9:15 pm

    @matthew – If only it was as easy as going for maximum yield. Remember that yields are historical, whereas prices are now, so high historical yield shows that the price has dropped. If this is because the whole market has dropped, then great, but if it’s because the company is about to fall off a cliff, then not so great.

    Of those you list, I hold Aviva and SSE. I’m pretty confident both will do well for me, but that’s because I bought into both at *very* low prices.

    Always remember that dividends can be cut, and often are. You need to make sure the business case is sound, the dividends well covered (not much less than twice) by earnings, and also look at their dividend record. If they have cut before, they may cut again, so it’s better that they are shunned until they have shown 5+ years of rising dividends before they see our money again.

  • 19 JohnG October 28, 2015, 9:41 am

    @accumulator: There’s a bit of me wonders how much use some of this article is. Obviously it’s true that starting saving younger probably makes the whole thing easier than later, but many if not most of the just turned 20 crowd reading this are probably already onboard with the idea.

    In my experience the real problem demographic is 40 and 50 somethings who did nothing, or very little, to save before. Now they’re looking at articles saying they need to save 5x, 6x, 8x, 10x, 15x harder than someone younger and it encourages the exact same “do nothing, because nothing can be done” response you’re trying to challenge.

    Someone who is 50 and decides to put away just £2k a year until retirement at 68 could have another £3k pa of income from retirement to 90 years old, which would considerably improve there position over just having the state pension. Thus if possible to message should be that although starting early is best, starting late doesn’t mean hair shirts until retirement and can still really up your income.

  • 20 Fraser October 28, 2015, 2:28 pm

    I’ve been adding AVCs through salary sacrafice. I now contribute 25% through AVCs in addition to the 5% which my employer matches. The Pension Scheme offered by my employer is L&G Global 60:40 Index. I’m not sure if anyone has views on this scheme. I’m 31 and my contributions to date are £39,197. The value of the fund is £47,926k. I’m not sure if this a good return to date but I think I might be better selecting my own investments although have no knowledge of low cost options with a better investment return.

  • 21 OH October 28, 2015, 2:43 pm

    Although I was pretty good at stashing cash away in an ISA when I started working (at 22, now 27)as I was living at home for some reason I held off my pension. Fortunately, I thought better of that and have now been on the scheme over 2 years now at least and the employer contribution has gone up from 5.5% to 7.5% to match my 4.5%. I’ve increased my own and with salary sacrifice it feels like my additional contributions are buy one get one free so I am likely to nudge it up further.

    The gains, as with my regular investments have been very moderate but in the grand scheme of things that’s not a big issue.
    I think exactly what you invest in is not so critical at the beginning if you’re young, what you are paying in eclipses any interest gains.

  • 22 ermine October 28, 2015, 5:07 pm

    @Fraser there’s not that much wrong with that L&G Global 60:40 index and if you’re getting sal sac then you benefit by the NI saving, which is still an extra 2% even in HRT. I have decent reason to be grateful for having the L&G 50:50 option that served me well through 2009 to 2012 🙂

    At realistic rates of return (5% real) and realistic working lives (ie the 30 to 40 year working life that most people reading this would probably prefer) compound interest roughly doubles your money by retirement. Worth having, but nitroglycerin is perhaps stretching a point. If you want compound interest to work harder than you did, then at 5% real there’s no other option than to be prepared to work for a nice long time, 40 years is okay, 50 is great. Most of us will get sick of it earlier than that so we have to save a bit harder…

  • 23 PC October 28, 2015, 6:52 pm

    Fascinating article and all good advice.

    Although looking back (almost 40 years) I would tell me 20 year old self not to worry too much, it’s possible to catch up later.

    My 20 year old self was a member of a non-contributory pension. When I left that first job after 6 years, my pension rights were locked away, at first frozen, then kept in line with the RPI and finally accessible as a transfer value. As someone above mentioned, I’m fortunate that my late 50s earnings are many times what my 20s earnings were and the value of my 20s pension rights are pretty insignificant now compared to the much larger amount’s that have gone into my SIPP later on.

  • 24 SemiPassive October 28, 2015, 7:20 pm

    “At realistic rates of return (3% real)”
    There we go, corrected for 2015 🙂
    And reduce further if you hold gilts.

    Actually on a less mischievious note one often quoted idea is that you can hold off pension investing to a degree until you slip into the 40% tax bracket and get more bang for your buck, which may well be over the age of 30. But this could all be about to change if the rumour mongering over culling 40% tax relief in the next budget is true.

    While technically simple to get rid of the tax relief top up on higher rate personal contributions,
    I am intrigued how they will achieve it against salary sacrifice or personally owned ltd company contributions which effectively duck people out of 40% tax or NI contributions. Yes these are subject to the annual allowane cap, but the money goes in gross from the employer company with no HMRC “relief” funding, so how could they reduce the tax relief?

  • 25 The Investor October 28, 2015, 7:57 pm

    @SemiPassive — Personally I wouldn’t ratchet down for lower rates of return. That’s just recency bias. 🙂

    Here’s what I wrote on this theme in November 2012, when gloomy was much more the fashionable garb of choice out there:


    Since then global markets are well ahead (e.g. ACWI MSCI Global ETF is up 37%).

    Somewhat ahead of the gloomy predictions at the time, though early days of course… 🙂

  • 26 Jim McG October 29, 2015, 10:13 am

    Regardless of the arithmetic, the principles of compound interest should be hammered into kids from nursery school. I’d never heard of the concept of compounding in relation to savings until I turned thirty. Fortunately, I had signed up for a lucrative DB pension scheme on my first day of work ten years previously, and every day now I say a little prayer of thanks to whatever inspired that stroke of a pen. In fact, put compound interest to one side. Encouraging kids (and adults!) to regularly save money – anything, even 50p a week in a jar – would be a massive step change in our current culture.

  • 27 Brendan October 29, 2015, 6:50 pm

    I take massive issue with the notion anyone has paid for their retirement by compound interest in the UK! The current retired generation – some ermines excepted – did very well out of leveraged investments. But it was the leverage, not the rate of increase, that did the bulk of the lifting here.

  • 28 gadgetmind October 29, 2015, 8:16 pm

    Compound “interest” also sounded odd to me as I’ve always kept cash allocation low, but I have done very well from equity returns in PEPs/ISAs and pensions.

    As for leverage, I’ve tended to keep mortgage borrowing down and have paid off the debt very early (1st house within 6 years, 2nd within 10 and small LTV on this one).

    So, in my case it’s very much my investment returns over the decades that will let me retire early and it’s nothing to do with gearing.

  • 29 The rhino October 31, 2015, 9:01 am

    I d probably lump reinvested dividends under the banner of compound interest.

  • 30 David November 19, 2015, 9:53 am

    The simple calculation used in the article made me think of my future… It might be a common problem to consider that you have enough time to start saving for pension (but not now of course, you are too young). But figures give the faithful representation of your situation. It’s great to understand that before it’s too late. Thanks for the article!

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