The joys of compounding

26 May 2018 9:00 AM

Saving half a million pounds into a pension pot seems a goal so large and unachievable that many don’t bother. Better to live, and spend, for today.

But what happens at retirement when tomorrow becomes today? Carpe diem will seem, in retrospect, a poor choice when faced with bills without a monthly wage.

Fortunately, you have to save significantly less to afford a comfortable retirement than you realise. People often overestimate how much they will have to squirrel away because they fail to appreciate the joy of compounding — earning returns on returns. And unlike the joy of sex, compounding offers no instant gratification: instead give it time and you can savour the pleasure.

If, for example, I invest £100 in a portfolio of global stocks today, by this time next year I might expect — thanks to dividends and capital growth —my investment to grow by 7 per cent, to £107. This would be in line with historic averages. The following year, assuming I reinvest the dividends and this performance is repeated, I will earn 7 per cent not just on my original £100 but also on the £7 I earned in the first year. That is compounding — and the longer you invest your money, the more magical the effect.


Let’s illustrate it with a simple example. Assume you start putting money towards your pension at 35 and save £5,000 a year. At 65 you will have saved £150,000. Assuming an annual return of 7 per cent, your pension pot will have grown to just over £500,000. Like a financial Rumpelstiltskin spinning straw into gold, compounding will have more than trebled the sum you invested — and earned a lot of retirement cruises.

No wonder Einstein is reputed to have described compound interest as the most powerful force in the universe. But compounding is far more powerful when the annual returns are higher. Let’s compare the above example — investing in shares — to putting that money into a bank savings account or buying UK government bonds. Both of the latter are deemed risk-free as you should always get your money back. But there is a cost to this safety; you earn less and that hurts (the pain of compounding very little — more Fifty Shades of Grey).

You can forget earning 7 per cent a year — 2 per cent interest would be a more likely long-term return. Assuming this rate at 65, your total £150,000 saved will only have grown to just over £200,000. That will make for a very different retirement lifestyle compared with having half a million to spend. To get to a £500,000 pension pot at 65, with safe savings or government bonds earning just 2 per cent a year, I would need to more than double the amount I save each year, putting by £12,000 p.a. over 30 years (not £5,000 p.a.).

I hear all the time ‘I’m not rich enough to invest in stocks and shares’. But most of us aren’t rich enough not to. Multi-millionaires don’t need their money to grow — it’s a big enough pile to start with. They just need to preserve what they have But the rest of us need our savings to grow and for that there is only one investment: stocks and shares. That’s because the world’s stock markets tend to go up over time as the global economy grows and as companies become more efficient and more productive. It is this long-term rising trend in GDP per capita that investing in shares captures.

The stock markets are not risk-free. Any market can fall 20 or 30 per cent in a year. But ignore it. Provided you have a long enough time horizon — and most of us do — then you just wait out the falls, keep saving and investing, and disregard what the market does short-term.

Nobody wants to lose money. I don’t — but I am prepared to because the cost of safety in this low-interest-rate world, is almost certainly going to prove far greater. One thing I am not going to do is to try to guess when markets are about to fall. Even if the US stock market, for example, does look expensive at the moment, it may still go higher — gains which I would miss out on if I sold. In the long term, you are better to stay invested.

Part of pension planning is accepting the risk and uncertainty. You can’t know the size of the pot you will have at retirement because it depends on unknowable things, such as stock-market returns and inflation. I understand I can do little about this uncertainty, other than accept it. But I save what I can afford, into global stock markets, relying on long-term economic growth, increases in productivity and financial maths to do the rest.

One thing I know I won’t be doing on retirement, though, is booking a cruise. I get horrifically seasick.