The benefit of earlier saving and the eighth wonder of the world!
Albert Einstein famously quoted that "Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it."
You may not completely agree with Albert, but compound interest is something we should all be aware of and means returns are earned on previously earned returns. This is worth understanding as it can significantly increase your savings over time, especially when positive investment performance is added into the mix (although this cannot be guaranteed).
Applying this knowledge makes it easy to see why earlier saving can significantly benefit you in your later years. If we illustrate this on a real basis i.e. taking out the effect of inflation (which is difficult I know in the short term, but consider a more normalised inflation rate for the purposes of comparison) and assume that the target return for our City Asset Management Real4 portfolio of CPI plus 4% is simply 4%. By illustrating a Real 4% growth over time for different starting ages, you might find the monthly saving amount required to produce a £500,000 investment pot at age 60, quite interesting.
Example assuming a monthly investment to meet a real value of £500,000 at age 60:
| Age at start of investment | Monthly investment amount | Number of years of saving | Total of monthly investments / savings |
|---|---|---|---|
| 20 | £429 | 40 | £205,920 |
| 30 | £727 | 30 | £261,720 |
| 40 | £1,369 | 20 | £328,560 |
| 50 | £2,397 | 10 | £407,640 |
You can clearly see from the above figures that if you start saving at age 20, then you only need to save £429 per month over 40 years to achieve an investment pot of £500,000 at age 60, versus a whopping saving rate need of £3,397 per month if you leave saving until age 50.
Using Personal Pension Contributions to further enhance returns
Taking the example above, and considering someone making personal pension contributions instead, the contribution needed is reduced thanks to the added power of tax relief. This means a basic (or nil) rate taxpayer achieves 20% tax relief on the contributions made, with higher and additional rate taxpayers achieving a total tax relief of 40% and 45% respectively (20% basic rate tax relief at source and an additional reclaim via self-assessment).
Plugging tax relief into the calculation further enhances the compounding effect of starting early as shown in the examples below (please note that contributions from age 50 have been omitted due to potential annual allowance limitations).
Basic rate taxpayer (earnings up to £50,270):
| Age at start | Net pension contribution (£) | Tax relief at source (20%) | Monthly pension investment amount | Monthly extra tax relief reclaimed (0%) | Net total monthly investment cost | Number of years of saving | Total net savings amount | Total investment value |
|---|---|---|---|---|---|---|---|---|
| 20 | £429 | £107 | £536 | £0 | £429 | 40 | £205,920 | £624,367 |
| 30 | £727 | £182 | £909 | £0 | £727 | 30 | £261,720 | £624,950 |
| 40 | £1,369 | £342 | £1,711 | £0 | £1,369 | 20 | £328,560 | £624,571 |
Higher rate taxpayer (earnings above £50,270, but below £150,000):
| Age at start | Net pension contribution (£) | Tax relief at source (20%) | Monthly pension investment amount | Monthly extra tax relief reclaimed (20%) | Net total monthly investment cost | Number of years of saving | Total net savings amount | Total investment value |
|---|---|---|---|---|---|---|---|---|
| 20 | £429 | £107 | £536 | £107 | £322 | 40 | £154,440 | £624,367 |
| 30 | £727 | £182 | £909 | £182 | £545 | 30 | £196,290 | £624,950 |
| 40 | £1,369 | £342 | £1,711 | £342 | £1,027 | 20 | £246,420 | £624,571 |
Additional rate taxpayer (earnings above £150,000):
| Age at start | Net pension contribution (£) | Tax relief at source (20%) | Monthly pension investment amount | Monthly extra tax relief reclaimed (25%) | Net total monthly investment cost | Number of years of saving | Total net savings amount | Total investment value |
|---|---|---|---|---|---|---|---|---|
| 20 | £429 | £107 | £536 | £134 | £295 | 40 | £141,570 | £624,367 |
| 30 | £727 | £182 | £909 | £227 | £500 | 30 | £179,933 | £624,950 |
| 40 | £1,369 | £342 | £1,711 | £428 | £941 | 20 | £225,885 | £624,571 |
You can see from these examples that taking advantage of tax relief on personal pension contributions along with compounding investment returns offers a compelling reason to invest early. An early investor who starts at age 20 and who is a higher rate taxpayer could expect to see the net cost of monthly contributions to fall to £322 per month, meaning that the total cost of contributions up to age 60 falls to £154,440, but still achieves a pension pot of £624,367.
This approach limits the net amount/ cost to you of payments over your lifetime, especially when allowing for extra tax relief for higher and additional rate taxpayers… if only we had all started earlier!
Please note that these examples scenarios assume that:
The gross pension amount (after basic rate tax relief) remains invested within the pension.
The extra tax relief reclaimed via self-assessment reduces the net cost of the pension contribution (in practice the reclaim is dealt with under a tax code adjustment or refund but these examples assume that this simply reduces the net (i.e. the amount you actually pay) monthly contribution amount for illustration purposes).
The investment returns are linear throughout the investment period.
In reality, the above outcomes depend on many variables and individual advice should always be sought. If you are interested in discussing your situation in more detail, please contact a member of our Financial Planning Team.
This article was prepared by David Bethell, a chartered financial planner at CAM. We always appreciate your feedback. If you have enjoyed this article or have any specific topics you would like to see addressed in future newsletters, please email us at FPTeam@city-asset.co.uk.