Our last article focussed on WHY you should invest in a pension, and we think we made a pretty compelling point. But we wanted to explain a bit more about why the WHEN you invest can have a big impact on the overall value of your pension.
We realise it’s a bit of a tough sell. When you’re in your twenties, a pension is probably the last thing on your mind. Somebody older, and considerably more boring, brought the subject of a pension up in a conversation with you once, but you immediately tuned them out. Pensions are for old people. That’s why they’re called pensioners!
And yet, investing into a pension early could be the best financial decision you ever make.
Why? Well, for quite a few reasons, really. But primarily, it is to make the most of some financial magic called compound interest which we touched on in our last article. If you’re after a short summary, this is it:
The earlier you start saving, the longer your money has to grow, the more money you end up with.
So let’s look at a quick example:
Let’s say we have two friends, Gemma and Dave. They’ve just reached 65 and are both set to retire.
Now, as well as retiring at the same time, they also invested exactly the same amount of money each month – £325, which amounts to £3,900 a year. You’d think this meant that they’d be retiring with exactly the same sized pension pot, wouldn’t you? Well, not quite. And here’s why:
Gemma was interested in finance from an early age. She’d been told about the magic of compound interest, and with encouragement from her family, she started to invest £325 a month when she was 20. It was hard, because she wasn’t earning too much at that stage, but everything she’d read said it was important. When she hit 40, she stopped investing, and the money stayed where it was in the pension, continuing to grow at a rate of around 5%.
Dave was much more of a carefree spender in his younger days and only started investing in a pension when he was 40. It was the same pension fund as Gemma, and he put in the same amount each month – £325. Dave decided to carry on contributing each month right up until he was 65, meaning he paid into it for 25 years in all – a full five years more than Gemma.
So, Gemma invested £78,000 in total. Dave invested £97,500 in total, which means he must have ended up with more, right?
In actual fact, Dave, who started investing much later, ended up with a great pension pot of around £220,000. Pretty impressive. But Gemma ended up with a pension pot more than double the size of Dave’s, at just under £495,000 – almost half a million pounds! Why? Because Gemma’s pot had decades longer to grow.
Einstein described compound interest as ‘the eighth wonder of the world’ and ‘the most important invention in human history’. The example above shows us why, but let’s try and explain it a little further, so we can see what’s actually happening:
Imagine that you put £3,900 in your pension pot today. After a year at 5%, you would have £4,095. Now, rather than withdraw that interest, you decide to keep it there for another year. If you once again earn 5%, your investment will grow to £4,299. Because you left that interest in your pension pot, it works together with your original investment to earn you £204, rather than £195 the previous year. An extra £9 might seem like nothing now, but over 40 years, it continues to grow and grow, and the amount that you earn for doing absolutely nothing gets bigger and bigger.
Gemma stopped contributing at age 40, when she had around £145,000 in her pension pot. And yet, 25 years later, without adding another penny, she had around £495,000. That’s the magic of compounding. Your money continues to work hard, even when you’ve stopped adding to the pot!
While the example above is a somewhat simplified view of things and is designed to illustrate compound interest, it doesn’t actually take into consideration the tax advantages of saving into a pension, which mean that both Gemma and Dave could benefit even more. Crucially though, with the tax implications factored in, the gap between Gemma and Dave would be even wider. We go into that a little bit more in our previous article.
So what does the story of Gemma and Dave tell us? Thinking about a pension in your 20s is probably the last thing you want to do; retirement, after all, seems a long way off. But with a pension, years count.
Start investing when you’re 20 and the 35-year-old you will thank you for it. He’ll have a massive head start over his peers, thanks to that decision you made. 50-year-old you will pat you on the back, and perhaps offer you tickets to the club lounge at your favourite football team. He’s checked his latest pension forecast and he knows that without adding another penny, he’s going to enjoy a luxurious retirement.
And 65-year-old you? Well, 65-year-old you could well be a millionaire. How good does that sound?!
So when should you start investing in a pension?
There’s an old Chinese proverb that lends itself well to a conclusion in an article about investing early:
The best time to plant a tree is 20 years ago. The second best time is now.
Start now, however old you are! And tell everyone else you know to start now too.
This article is for general use only and is not intended to address your particular requirements. It should not be relied upon in its entirety and shall not be deemed to be or constitute advice.
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