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Many people underestimate how powerful even small pension contributions can be over time, or might perhaps think that it’s too late for them to make any meaningful difference to the pension savings they’ve already built up.
That’s where compounding comes in. It is one of the most powerful forces behind pension growth, and understanding how it works could make a significant difference to your retirement income when you stop working.
Here, we explain how it works and how to make the most of it.
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If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide Chartered independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial adviser. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 2,600 reviews on VouchedFor, the review site for financial advisers.
What is compounding?
Compounding is what happens when the returns on your savings or investments start to generate their own returns.
In simple terms, it means you earn interest not just on the money you put in, but also on the interest or investment growth that builds up over time.
For example, if you invest £10,000 and it grows by 5% in a year, you’ll have £10,500. If this pot of money grows by another 5% the following year, you won’t just earn interest on the original £10,000, you’ll earn it on £10,500. Over time, this snowball effect can become increasingly powerful.
Even if you aren’t adding to your pension regularly, compounding means that your pension will effectively be topping itself up as time passes.
Imagine you are aged 50 and have a pension pot of £20,000 that grows at an average of 5% a year.
- After 5 years, it would grow to around £25,500
- After 10 years, it would reach roughly £32,600
- After 15 years, it could be worth about £41,600
What’s striking about this example is how growth accelerates over time. In the early years, increases may seem modest. Later on, however, the gains become much larger, even though the growth rate hasn’t changed.
Obviously, the sooner you start saving, the more impact compounding will have, but it’s important not to feel discouraged if you’re starting later. Compounding can still work in your favour, it just has less time to do so. Learn more in our guide Five reasons why it’s not too late to start saving into a pension.
The importance of regular contributions
Compounding isn’t just about paying a lump sum into your pension and leaving it there. Making regular contributions can make a big difference too, as every pound you pay in has the potential to grow over time.
If you belong to a workplace pension scheme, you’ll usually have been auto-enrolled into your employer’s workplace pension scheme, and so will be paying into your pension every month already.
The minimum contribution under auto-enrolment is 8% of ‘qualifying earnings’. Of that 8%, your employer can’t contribute less than 3%, but they can pay as much of the 8% as they want. Your payslip should show any pension contributions that are deducted each month. Learn more about automatic enrolment in our guide How does pension auto-enrolment work?
If you have a private pension, then ideally you should pay in as much as you can afford every month, but the exact amount will depend on your individual circumstances. Find out more in our article How much should I pay into my pension?
What affects how quickly your pension grows?
Several factors influence how much your pension can benefit from compounding and these are likely to change over time. They include:
Investment returns
Higher returns can significantly boost your pension over time, although they usually come with higher risk. Pension funds are typically invested in a mix of assets like shares, bonds, and property, with many automatically moving your savings into lower risk investments as you approach retirement, due to a process known as lifestyling.
However, with many of us working for longer and opting to leave our pension savings invested in retirement so we can take an income from them via drawdown, moving into low risk investments relatively early on might not always be the best option. This is because over long-term periods, shares tend to perform better than cash and gilts, although of course there are no guarantees.
It’s really important to understand where your pension is invested so that you know what level of risk you’re taking, and how much you’re likely to end up with at retirement. Learn more in our article Where is my pension invested?
Time spent in the market
Even if retirement isn’t far away, your pension could still have a decade or more to grow, especially if you don’t plan to draw on it straight away.
Time spent invested is one of the most important factors that helps compounding have the biggest impact possible. The longer your money is invested, the more opportunity it has to grow. But that doesn’t mean if you’ve only got five or 10 years to go before retirement it isn’t worth paying more into your pension.
In fact, if you’re in your 50s or 60s it could be even more worthwhile paying into a pension if you’re looking ahead to retirement, as you’ll still qualify for tax relief on your contributions up to the age of 75 and you’ll also be able to access your pension savings (including the top up from the taxman) much sooner than someone younger. Read more in our guide How pension tax relief works.
Fees and charges
Charges can eat into your returns, especially over long periods. Even small percentage fees can make a noticeable difference over decades, so it’s really important to understand how much you’re paying.
Camilla Esmund, Senior Manager at interactive investor, said: “It can be disheartening to integrate good habits, stick to your investment strategy for the long term and see the fruits of compounding take effect over time, only for your growing pot to be eaten away in unnecessary fees. Over decades, the differences can add up to tens of thousands of pounds. Importantly, paying over the odds means less wealth for you to enjoy down the line.”
If, for example, you have one older pension which charges much higher fees than your other pensions, you might want to think about consolidating this with your other savings, as long as it doesn’t mean giving up any valuable guaranteed benefits. Find out more in our article Could consolidating your pensions save you money?
Inflation
Inflation reduces the real value of your money over time. This is why it’s important that your pension investments aim to grow faster than inflation. Learn more in our article How does inflation affect my pension?
Common mistakes that can reduce your pension growth
There are a few common pitfalls that can reduce the benefits of compounding:
- Delaying pension saving – the later you start, the less time your money has to grow
- Pausing contributions for long periods – this interrupts the compounding process
- Being too cautious for too long – overly conservative investments may not grow enough to keep pace with inflation, although you should never take a higher level of risk than you’re comfortable with
- Withdrawing money early – this reduces the amount left to compound
Avoiding these mistakes wherever possible can help you make the most of your pension.
A final thought…
Compounding is one of the most powerful tools available when it comes to building your retirement savings, working quietly in the background to boost your pension
By starting as soon as you can, contributing regularly, and staying invested over time, you can give your pension the best chance to grow into the nest egg you need to fund your retirement.
Clare Moffat, Pensions and Tax Expert at Royal London, said: “Increasing pension savings can help, but with everyday expenses rising, boosting contributions may not feel like a priority. However, simple steps can make a difference. At your next pay review, can you put your pay rise towards your pension contribution, even by a little? Pension contributions benefit from tax relief, the government top-up, as well as the power of compounding. What may seem modest now could make your retirement much more comfortable.”
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If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide Chartered independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial adviser. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 2,600 reviews on VouchedFor, the review site for financial advisers.
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