About the use of compound interest, the eighth wonder of the world.

Talk to a typical young uni student about pensions and ‘old people’ and immediately eyes will glaze over and brain disengages itself from any idea of intelligent thought, switching across to ‘I’m in a lecture so can catch up on lost sleep’ mode. (To most students, ‘old’ means staggering around on a zimmer frame and probably smelling of cats – just wait till they are ‘old’!!!) However what about compound interest!

Have a think on this…

Let’s take a guy (and I’ll use the term ‘guy’ and ‘he’ as totally gender neutral terms) who, regardless of state pension age, would like to retire at 65 and has now reached 55. There will be the realisation that the ‘wonderful work pension scheme’ is not as ‘wonderful’ as it first appeared. Retirement time is now down to single digit number of years, it’s time to do something!!! So he decides to save £100 a month (£1,200 a year) into an investment based savings scheme.

If you look back at long term stock market returns (and I do mean long term) then you’re looking towards around a return of 8% a year. This may well be made up of around 4% or 5% of raw company growth and 3% to 4% dividend return. (This is only an average, there will be some fantastic years of gain, many relatively neutral years, some of actual loss – this just has to be lived with – but over say 50 years 8% is not unreasonable.)

So back to our guy with his £100 a month. (Remember that if we are looking at monthly growth over time we are looking at *compound* interest rate growth.) Throw our investment figures into a compound interest rate calculator or compound spreadsheet formula and see what you get. Over 10 years the cost in contributions will be £12,000 (£100 month x 12 months x 10 years) but working with our 8% getting back after this 10 years around £18,500. Take from this the £12,000 paid in and you’re left with an overall gain of £6,500. Not too bad (and I won’t even bother asking what you would have got by leaving it in a typical bank account!).

However…

Let’s take the guy at age 45. (Probably just come out of mid-life crisis, realises he is now ‘old’, getting out of bed in the morning is not anything like as easy as it was…) Decides to do the same thing of £100 a month for the 20 years that will lead up to 65. Total cost will be £24,000, however a 20 year return at 8% should bring in something around £59,000. Subtract from that the £24,000 paid in and you’re left with a £35,000 gain (or nearly 6 times the amount of the 10 year person!).

Let’s go one step further and someone aged 35. (Done education, got job which meant a lot of travel but now wants a bit of stability while children are at school.) So we’re looking at 30 years at £100 a month. Total cost, £36,000. Reward at 65, £150,000. Subtract the £36,000 cost and left with £114,000 profit.

Quickly move on to the 25 year old. (Finished education, has settled down into a job so now wants to save.) For the 40 years till 65 will cost £48,000, the reward being £350,000. Remove the £48,000 paid in leaving a profit of £302,000.

A quick summary:-

10 years, cost £12,000, reward £18,500 net gain £6,500
20 years, cost £24,000, reward £ 59,000 net gain £35,000
30 years, cost £36,000 reward £ 150,000 net gain £114,000
40 years, cost £48,000 reward £ 350,000 net gain £302,000

A final variation on this. It would be a bit unreasonable to expect a college or Uni student to save £100 a month, so let’s take the sum of £30 a month. (A cost students can relate to; a monthly phone contract, the cost of pizza, cinema then beer, Saturday night party…) Take a 18 year old student and do this £30 a month for 5 years. The cost £1,800, which will provide a sum of around £2,200. Take this £2,200 as an initial investment lump sum and leave it there for the next 42 years. (Not adding anything further to it.) At 65 look forward to getting back almost £63,000.

When it comes to saving, time is everything.

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