The Benefits of Early Pension Investment
As a scheme that sets us up for retirement, it’s easy to brush pension contributions off as something to think about later. Retirement may be decades away. If you’re adding to a compulsory employer pension scheme, you may feel it’s already under control. To a point, of course, it is. But when you crunch those numbers and calculate what may await you in later life, chances are you will feel a little more motivated to top up that pot.
Unfortunately, most people realise this later in their life, when they’re starting to think about setting themselves up for retirement. While it’s never too late to beef up contributions, being proactive before your 40s, 50s, or even 30s is the best way to really capitalise on compounding; something Albert Einstein is said to have called “the most powerful force in the Universe”.
For example, which of the following scenarios produces a bigger savings pot?
Scenario 1) £125 per month saved for forty years, growing at 7% a year (total invested £60,000) or
Scenario 2) £500 per month saved for twenty years, growing at 7% per year (total invested £120,000)
Surprisingly the answer is Scenario 1. This produces a savings pot worth around £326,000. Scenario 2 costs you £60,000 more and is only worth around £259,000.
Welcome to the World of Compounding
Investing is a powerful means by which to potentially increase wealth. Unlike simple cash savings, investments, including pension schemes, can amplify your efforts. The longer your money is invested, the more it has the opportunity to grow.
Let’s explore another example.
Sam is a practical 20-year-old who understands the value of investing early. Sam doesn’t have a lot of money to invest, but realises that contributing something is better than nothing. Sam diligently invests £50 a month until reaching 60.
Jessie, on the other hand, barely thought about a pension until turning 40. Crunching some numbers, Jessie realised extra contributions would be necessary to reach their pension goals by age 60. To try and catch up, they invested £100 a month.
Theoretically, come age 60, both will have invested the same amount (£24,000). Assuming the same investment return of 7% per annum, thanks to compounding, Sam is sitting on a pot of around £130,000, while Jessie has around £51,000.
Not to Mention Tax Relief
If compounding didn’t do it for you, wait until you hear about the benefits of tax relief.
What is tax relief, you ask? Basically, the government gives you extra money when you put cash into your pension. Personal contributions are currently topped up by 25p for every pound invested. So, if you pay in £80, tax relief increases your contribution to £100.
Those paying higher rate income tax can claim a further bonus of an additional 25p tax rebate for every pound contributed. So, the same total contribution of £100 (£80 plus £20 basic rate tax relief) would actually only cost you £60 with the extra tax rebate.
For Jessie, who is a higher rate taxpayer, their £100 monthly contribution is ‘grossed up’ to £125, and they can get another £25 back via their tax return, making the net cost £75.
Sam may only be taxed at 20%, so their £50 contribution goes up to £62.50. Jessie now has a huge advantage. However, with Jessie only contributing for 20 years, they’re still short of Sam. Sam has over £160,000, and Jessie has made it up to about £65,000.
How about some Tax-Free Growth?
Not only do you get an immediate financial boost for putting money into your pension, all of the money you put in there (including the tax relief) can grow entirely free of tax until you retire. Every pound invested works as hard as it can for you. With almost any other form of saving, you start with a smaller amount (because there’s no tax relief). So, assuming the investment returns are the same, you are almost always better off in the long run with a pension.
The Time to Start is Now
Sure, compounding can work for you through other investment strategies, and there are many worthy investment strategies that you can and should explore when building wealth. All have their pros and cons. However, we believe it should always be a case of pension plus X. Never pension or X.
The sooner you start to invest in your pension, the harder you make your money work for you. Consider the examples above. Pension schemes allow modest earners with financial foresight to be potentially wealthier than their higher earning peers in retirement. You don’t have to go big. You just have to start now.
To help you set up a pension strategy to reach your long-term goals or make your first steps, contact the team at Wise Investment for a free consultation.
The above information is for educational purposes and is not a personal recommendation or investment advice. Content is accurate at the time of writing and tax limits and rates may change. Pension funds cannot usually be accessed until age 55 or 57. If you are unsure about the suitability of a particular investment you should speak to an authorised financial adviser. The examples shown are for illustrative purposes only and don’t take into account the impact of charges. The value of investments can go down as well as up and returns are not guaranteed. There is an annual allowance for pension contributions and anyone putting more into their pension may have to pay additional tax. High earners will also have this annual allowance reduced but the details of this are beyond the scope of this article. Wise Investment is authorised and regulated by the Financial Conduct Authority (FCA 230553).
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