Delaying starting a pension, even by a year, could cost you a fortune down the line. In fact, according to new research from Hargreaves Lansdown, skipping a trifling £600 contribution could make you £43,000 worse off in retirement!
And seeing as the government has said they’re delaying the automatic enrolment of employees without a pension onto the National Employment Savings Trust (NEST) scheme, this is what’s facing many workers out there.
On the face of it, these figures (which I’ll run through) are a great reminder of the power of compound returns. But we need to look a little closer.
Because I think there is a serious problem here that many investors will miss – something I reckon could save you a great deal of money if you are wise to it.
How a £600 contribution ends up as £43,000
In the example I just mentioned, it’s a 22 year-old basic rate taxpayer that skips his £600 contribution. It’s assumed that he’ll work until he’s 67, which means that his contribution has got 45 years to grow.
But on top of his missed £600, there’s an employer’s contribution that would have been £450 and £150 in tax relief. So it’s actually £1,200 that he would have been starting with.
I’ve just crunched the numbers. To get £1,200 to grow to £43,000 over 45 years you’d need a compound return of around 8.3% a year. And that’s not taking into account any fees.
Now, of course, an 8.3% return, year in year, out for 45 years will never happen. The eighties and nineties were great years on the stock market, but I suspect we’ve seen the last of those sorts of wonderful returns. I’d reckon on a more sober 5% a year – especially when you consider that you’re not likely to plump the whole lot on equities. With an average return of 5% over 45 years, £1,200 ends up at just under £11,000.
Phew. That poor young man isn’t really likely to be £43,000 worse off just because the government’s postponing his pension plan for a year. But, even £11,000 is worth having, given that the saver is only putting up £600 out of his own pocket.
Whether you use 8% or 5% for your calculation clearly makes a massive difference. But what matters even more is what returns you get during the first few years of the savings plan.
Allow me to fiddle the figures and I’ll show you what I mean.
So we’ve just seen that a £1,200 contribution gets to around £11,000 with 5% returns.
But you’ll end up with £17,000 if you get five good years at the start (with returns of 15%) even if returns fall back to 5% after that. That’s the interesting thing about compounding. What happens near the beginning of the period has a massive bearing on the end result.
And if you get some losing years at the start, you’re in trouble! If I assume just three bad years (losing 10% per annum) and then 42 positive years averaging 5%, then forget about that £43,000! All you end up with is a lousy £7,000. But of course, we don’t have a clue what returns we can expect over the coming years. All we can do is our best.
Three things to do
It’s easy to use a spreadsheet to play around with compounding returns. I mean, last week alone the FTSE returned around 7%. Annualise returns like that and we’d all be loaded in next to no time.
But I wouldn’t pay too much attention to all those projections and print-outs you’ll often get from financial advisers. If you aren’t in a defined benefit plan, then you’re at the mercy of the markets, these projections are estimates built upon guesswork.
Yes, it’s good to have some target returns in mind, but ultimately all you can do is play the right game.
Here are my three tips on how to play the right game for the next few years.
Cut down on management fees
We are in a low return environment. Interest rates are on the floor and have been for three years. They could be there for many more. If all you can expect is a 5% return, then you can’t afford to hand 2% of that over to a fund manager.
Today, there are loads of ways to take control of your investments and cut out expensive management fees. Use ETFs, investment trusts and individual bonds and shares. Tuck them away in a SIPP or Isa and you can avoid many wealth destroying fees.
Get the best return you can while playing it safe
Recently I’ve been making the case for certain bonds that I feel are a good way to get an inflation busting return in this low return environment. I know these are difficult times, but if you accept negative real returns now, they’re going to put a big dent in your final savings pot down the line.
Most important of all, get your asset allocation right
While we all want decent returns, we have to mitigate risk. We can do that with intelligent asset allocation. Spreading your assets among cash, stocks, bonds, property and commodities can help diversify risk.
In Friday’s Right Side I want to go into more detail on asset allocation. I’ll explain why my assets are currently allocated to 25% cash, 25% shares, 25% bonds (mainly corporate) and 25% other (including commodities and precious metals).
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