Worryingly, many Brits don’t understand it. That’s a problem. Because if it isn’t working for you, it may be working against you. So what is this miracle? Compound interest. It’s what makes our savings, pensions and investments grow so forcefully over time. Put simply, it describes the process where you earn interest on the money you originally put away, then even more interest on the interest you’ve previously earned. And it keeps compounding, year after year, in what’s called the snowball effect.
It works wonders for investors. Especially those who start putting away money when they’re young, which means they have decades for this little miracle to work it’s magic. Too many of us fail to understand the stunning wealth-building power of compound growth, and could end up poorer in retirement as a result.
The compounding effect is a disaster for those who owe money, especially high interest debt such as credit cards. While Einstein saw the wonder of compound interest, he also warned of the dangers warning: “He who understands it, earns it. He who doesn’t, pays it.”
New research from retirement specialist Standard Life shows how years of investing can transform a pension pot over time. Its analysis of government figures found that investment growth accounted for around £65,000 of a typical £100,000 defined contribution pension pot, or 65%.
Individual contributions accounted for £18,000, employer contributions £13,000 and tax relief £4,000. That’s £35,000, or 35%. Two-thirds of a typical pension pot comes from compound growth, but incredibly, three quarters of people don’t realise it. Many more thought their own contributions made the biggest difference.
Jenny Holt, customer savings & investment director at Standard Life, said compound investment growth is one of the most powerful forces in pension saving “Contributions are important, but the real benefit often comes from giving them time to grow and generate returns over decades.”
That makes starting early particularly valuable. Standard Life found that someone starting work at 22 on a £25,000 salary and paying minimum auto-enrolment contributions of 5% and 13% from their employer could build a £210,000 retirement fund by age 68, adjusted for inflation. These figures assume 3.5% annual salary growth and an average total investment return of 5% a year after charges.
Wait five years until 27 to get started and the projected pot falls to £170,000, a shortfall of £40,000. Holt said modest contributions made earlier in your working life roll up because they have longer to benefit from compound investment growth. “Delaying can mean missing out on the years when your money could have been working harder for you.”
Investment returns aren’t guaranteed but the earlier you start, the longer your money has to overcome short-term stock market volatility.
