Just how does your pension work?
In prior articles we talked about why you need to plan for your retirement and the many benefits of joining your employer’s workplace pension scheme.
If you’re reading this article we’re assuming you’re on-board for the journey and the wheels of your retirement planning train have already left the station….
In many ways, saving for your retirement is identical to any other form of saving. In return for locking your money away someone has to pay you for handing over your hard earned cash to them.
The beauty of saving for your retirement is that if you start early you have a very long time (between 30 and 40 years) until you expect to retire and start drawing your pension. If we assume you are able to earn an annual interest rate of 5%, in return for investing £100 today it will be worth £105 in a year’s time. If you also earn 5% the following year you earn not only another £5 but also 5% on the £5 interest you earnt during the prior year. This means instead of earning £5 interest during the second year you’ll actually earn £5.25. This phenomenon is called compound interest and over longer time periods it becomes your best friend in helping you achieve your savings goals.
Isaac Newton once described compound interest as the eighth wonder of the world. Those who understand it, earn it. Those who don’t, pay it.
You’ll remember from prior articles that the UK government provides generous tax relief to incentivise us to save for our retirement. For most of us, if we save £1,000 today, depending on the rate of income tax we pay, we receive between £300 and £400 tax relief (so it’s closer to only £600–700 out of our pay cheque).
To show you a worked example, let’s assume you’re a 25 year old earning £30,000 p.a. You sign up to your company pension scheme and in return for contributing 4% your employer also matches that 4% contribution too. The total contribution paid into your pension is therefore 8% of your salary (£30,000 x 8% = £2,400). I.e. You’re investing £2,400 now for your retirement.
Over the next year that investment earns 5% interest and continues to do this in future years too. Prior to reading this article you might expect it to be worth £2,400 (the initial contribution) plus 40 years of interest (40 x £120 = £4,800), so around £7,200 when you reach 65. However, Because each year your investment returns from prior years also earn interest too it will actually be worth more than double that amount at around £16,900. Compound interest and a long timeframe actually provide the majority of the investment return!
Assuming you’re a standard UK tax rate payer your 4% contribution also received tax relief and national insurance relief so that £1,200 contribution was only actually £840 (so around £70 a month). By foregoing that £70 from your monthly pay cheque for the next 12 months (which is cheaper than most cable TV packages or gym memberships), you can expect to have around £17,000 to help fund your retirement at 65! A long timeframe, compound interest and the tax incentives offered by the government really do make joining your employer’s pension scheme a no-brainier!
The next blog post will describe how those investment returns are achieved in practice.
