Setting up a pension plan can seem like a demanding task at first. Putting money away today, in the hopes that you will be able to achieve a comfortable retirement, makes sense from a long-term perspective. However, if you are already struggling on a day-to-day basis to make ends meet, saving for the future might feel like a waste of time.
Nevertheless, it is important to start saving for retirement as soon as possible. Even if you can’t contribute much today, the sooner you start saving, the less you will have to save over the long-term.
At first glance, this statement might appear confusing. How is it possible to save less and still achieve a comfortable retirement?
Well, it all comes down to the power of compounding.
The power of compounding
Once described as the eighth wonder of the world by Albert Einstein, compounding is the most powerful tool in every investors’ arsenal.
Compounding, or compound interest is the addition of interest to the principal sum deposited. By reinvesting your interest on the principle, in the next interest period, interest is earned on the principal sum plus previously accumulated interest. In other words, by reinvesting, your money starts making money with no extra effort on your part.
Over the long-term, as long as you continue to reinvest interest, the returns will really add up.
A simple example illustrates just how powerful compound interest can be over time. If you make a small £100 deposit in a savings account yielding 5%, the account will produce interest of £5 per year. If you take this money out and spend it, that’s all you’ll receive. However, if you reinvest the interest over a period of 10 years your initial £100 investment will grow to £165 and it will be earning £8 a year in interest.
In another example, if you make the same £100 initial deposit and add £10 every month, over the course of a decade your savings pot will grow to £1,724 according to my figures. Of this total, £424 is interest earned on capital.
The two examples above clearly show the power of compound interest on long-term returns. The higher the rate of interest received, the more powerful the compounding.
Compounding with stocks
Over the past 20 years, the FTSE 250 has produced an average annual return of approximately 8.5%, that’s including dividends. At this rate of return, it does not take long for your money to start multiplying.
If you deposit £100 a month for 10 years, at a rate of return of 8.5% per annum, at the end of the decade your savings pot will be worth £19,180, even though the total value of deposits over the 10 year period is just £12,100. The remainder is interest earned (or in this case interest and capital growth).
With compound interest, the longer you can let the power of compounding do its work, the better. Extending the compounding period in the example above from 10 years to 50 years gives a final sum of £974,600. That is nearly £1m in savings just by depositing £100 a month.
The simple take away from all of this: If you want to have a comfortable retirement, it pays to start saving as soon as possible.