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.

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. [↩]

Good reads from around the Web.

One reason I’m still blogging about investing eight years after I began is because I keep learning new stuff even while trying to explain what I think I already know.

But another reason is because it reminds me of what I actually do already know.

Investing is not like electronic music or frontier physics – you don’t need to keep reinventing the wheel.

But you do need to remember that you don’t need to keep reinventing the wheel.

Sticking to a few stratagems will get you a long way, as Darrow Kirkpatrick explains in his short course on investing:

You can commit a large chunk of your life to becoming a better investor, if you want.

You can read articles, devour books, and enroll in classes. Some people, myself included, will take that full plunge.

But in the end, most experienced investors arrive back where they started, with just a few simple principles in hand.

His post quotes me alongside the likes of Warren Buffett and Harry Markowitz, so Darrow clearly isn’t infallible. 😉

But his short course is well worth the price of admission – a cup of tea, and ten minutes of your time.

And while we’re doing homework (or ‘revising’ for most of us, I hope) your next stop could be Michael Batnick’s clear overview of how to think about long-term returns.

Why? Because, as Batnick writes:

Past performance is absolutely not predictive of future results.

Data can be manipulated!

Sticking with an investment plan during a bad year (or a series of bad years) is what will make them successful.

The results of diversification are predictable even if the results of an investment are not.

His full refresher is at Enterprising Investor.

[continue reading…]

I read an article on dividend growth in the US, and asked an income fund manager contact for his view from a UK perspective, which follows. (He’s ended up posting anonymously to save all the bother of not doing so.)

Capita has just published its latest analysis of the dividends that have been paid out by UK companies.

It found that third quarter dividend payments were at a record high.

See Capita’s graph, above right, and note it’s the green bars that show how regular dividends have grown.

Capita also warns, however, that the growth of distributions is slowing, and that dividend cover is shrinking.

Many people put a lot of faith in dividends and rightly so, but that should not mean our love is blind.

Dividends, like lots of numbers in finance, are both a target and a measure. They provide income and, if reinvested, contribute to capital growth.

They can also tell us how healthy – or not – companies are.

Dividends bounced back

The graph below (derived from Bloomberg’s collation of forecasts from analysts) shows the amount of cash that UK companies expect to pay out as dividends one year ahead (excluding special dividends) relative to a UK market capitalization-weighted index:

Two things stand out.

One is the sickening lurch downwards in 2009. This came as the big UK banks discovered that they hadn’t actually earned any money from all their clever traders, PPI salesmen, and borrowers, and so could not pay it out as dividends.

The second feature is the overall rise in distributions since the trough of 2009 to the peak earlier this year.

This rise in payments – from £59 billion in 2007 to over £91 billion in 2014 – has underpinned much of the recovery in the stock market since March 2009, which you can see in the red line.

The desire for yield is a powerful motivation in a near-zero interest rate world.

What goes up…

Recently, however, the trend is downwards.

Expectations are that dividends next year will be about £87 billion, notably lower than the £91.7 billion predicted as recently as April.

There have been some high profile cuts already, the two biggest being Standard Chartered and Glencore.

We learned last year that Tesco would cut its payments, too.

On top of that there is a background of profit warnings from a lots of smaller companies that have been hit by lower growth rates in China, a slightly stronger pound, and what’s simply a super competitive environment in the UK where the lack of inflation makes it difficult to raise prices and margins.

Down with dividends

Every data analyst knows that correlation is not causation.

Nevertheless, if the market had not risen as dividends did, its yield would be 50% greater than the current figure of 3.7%. That would make it even more attractive against gilts yielding less than 2%.

This suggests the increase we’ve seen in capital values has been warranted.

Everyone likes the warm feeling generated by rising capital values but we should not ignore the slower, tortoise-like returns from reinvesting dividends.

What we really don’t like is a sudden suspension as happened with Tesco, where investors faced the double whammy of falling capital values and lower income.

At least the slow motion car crash in the commodity sector has been a warning to investors that its dividends were under threat.

When Glencore succumbed to the inevitable, its cut and associated fund raising was not a total surprise. A yield of 11% on Anglo American indicates investors have similar fears there, too.

There are doubtless many more companies where directors are maintaining distributions in the hope that this positive ‘signal’ overwhelms the few nerds who actually look at the cash flow statement and question dividend sustainability.

The Financial Times quotes the current dividend cover for the FTSE All-Share Index at 1.59 but I don’t have a figure for the projected dividend cover.

Even if I did I probably wouldn’t believe it because so many executives are remunerated with share options based on adjusted earnings per share figures.

In my opinion, these are fantasy figures to make bosses richer.

Dividends, by contrast, are real numbers backed by cash, to makes shareholder richer.

That is why they tend to rise more slowly.

No need to panic

Low dividend cover and falling dividends are big red flags hanging over this market.

Does that mean sell?

Not to it doesn’t. But it does mean we have probably reached the end of this business cycle.

So what? Another one will start soon and the process can begin all over again. Then the question will be when to buy.

Why risk getting two decisions wrong when the alternative is to sit tight, stay invested, and let those dividends you still receive after the cuts do the heavy lifting by reinvesting your income through the bottom of the cycle?

That way you will be fully invested at the start of the next upturn.

Perfect!