From houses and holidays to marriage and babies, twenty-somethings are expected to save for many of life’s great milestones in a short period of time. So when experts recommend we save 12% of our salaries (are you mad?) for a comfortable retirement, the financial burden of ‘adulting’ can understandably seem a little overwhelming.
With retirement so far away, surely it would make sense to prioritise the more urgent matters first, right? Well, maybe not. While it may seem logical to buy a house first and get your dream wedding sorted before saving into a pension scheme, delaying your nest egg might not be the wisest decision. In fact, as I explain later in this post, it could see you missing out on a huge chunk of ‘free’ money.
When I first started saving for a home of my own a year and a half ago, I reassured myself I’d start saving for retirement once I’d moved into my own place. However, with some experts warning that future pensioners are likely to need around 2/3 of their pre-retirement income, I’m suddenly wondering how the hell I’m going to save all that money in time!
I’ve realised I need to start NOW! After all, my future self matters. When wrinkly old Jenni is able to enjoy a slap up meal at the local cafe and watch TV in the evening with the heating on at the age of 80, she’ll be grateful to 25-year-old Jenni for being sensible and starting a pension early.
And do you know what the best thing is? Starting my pension fund right now can really work in my favour because of a magical thing called compound interest.
Before reading on, please note that I’m only just starting to save for retirement, I’ve never invested money, and I’m obviously no financial advisor and so at no point in this post am I giving you actual advice 😉
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Compound interest is your mate!
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” Albert Einstein
I’m not even kidding, Einstein actually said that. He even called compound interest the ‘most powerful force in the universe’.
If you have no idea what compound interest is, don’t be embarrassed because a few weeks ago, I didn’t either.
Basically, compound interest is when you place a sum of money in a savings account and it earns interest which snowballs over time to accrue even more interest. Think of compound interest as the interest you earn… from the interest you earn.
I’ll break it down into two simple examples:
Example 1: Saving for retirement in a savings account
Let’s imagine you put £1,000 into an account that earns 3% interest each year. Thanks to this interest, after 12 months you’ll have £1,030 in your account.
In the second year, you’ll be earning 3% interest on a larger sum of money, even though you haven’t placed any more money in the account yourself.
After 40 years, this £1,000 will have grown to £3,262. That may not sound like a huge increase (and inflation will probably have had its wicked way with the economy) but, for the sake of explaining how compound interest works, you’ve had to do absolutely nothing to this money in this time. Your original £1,000 has been snowballing around in your account picking up more and more money for free. In order to boost your savings to a more impressive level, you could split your money between different accounts with higher interest rates. You could also consider contributing to an employer pension scheme.
Alternatively, you could invest the money. Obviously investments are not completely risk free, but considering retirement’s a long way off yet, if your investment’s value decreases, you should have time for it to go back up.
Example 2: Investing to grow your retirement fund
Tom and Sarah have been inseparable ever since they met at university at the age of 18. Both born in 1990, they’re now 25 and starting to think about their future together. They’re saving to buy a house, but Sarah thinks it’s time to start saving for retirement too and wants to invest money to gain a really good return. Tom isn’t so sure. He wants to wait until they’ve bought a house and have got married before thinking about their pension.
Sarah decides to go ahead and start saving for retirement at the age of 25. She’s on a decent wage but doesn’t have that much to spare, so she invests £100 every month for 40 years. Let’s imagine every month she gets a 1% return* on average. By the time she’s 65, this figure has grown to £1.17 million. Keep in mind, she only contributed £48,000 of her own money herself. The rest of the money came as a result of compound interest.
Tom waits until he’s 55 to start saving for retirement. Since he’s earning a much higher wage now than Sarah was at the age of 25 (and he wants to prove he can catch up with her), he invests a huge £1,000 every month for 10 years. Like Sarah, he also gets a 1% return each month on average.* By the time he’s 65, his money has grown to just £230,000. Over the course of 10 years he saved just £120,000 of his own money. So when you think about it, the return he received isn’t anywhere near as impressive as the return Sarah received.
Obviously Sarah will have been saving for retirement for a much longer period of time than Tom. However, she’s grown her savings massively with a relatively small amount of money each month. This really does go to show that TIME IS YOUR FRIEND and the sooner you start saving, the better!!
In theory, even if you started saving now and stopped after 10 years, the money you’ve saved (along with the interest you gained before you stopped saving) should quietly continue to gain MORE interest while you carry on with your life. Compound interest is
sneaky amazing like that! I never thought I’d say this but, God bless maths!
The sooner you start saving for retirement, the better. By starting your retirement fund now, you can afford to put a much smaller amount of money away each month than you’d need to if you started saving in 10, 20, or 30 years time. This is because when you start saving early, you give compound interest the opportunity to grow and grow as each year passes by.
Over the next few weeks I’m going to be talking about saving for retirement quite a bit on Can’t Swing a Cat, looking at everything from the best places to save for retirement, to the amount you should try to put away. So if you’re interested in saving money for your future self to enjoy when you’re old and wrinkly, keep your eyes peeled!
*Please note that I’ve used 1% interest per month in this example rather than per year. If you were to get 1% interest per year, your final retirement fund would wind up much much lower than the example above. This is because your interest isn’t given as many opportunities to ‘compound’ itself. Frequency is key, which is why time is extremely valuable when it comes to saving for retirement.