Pensions and Compound Interest
The good news is that that your pension fund will “compound” its interest. This is where the interest your savings have earned goes on to earn interest itself. Here’s how it works:
If you save £1,000 every year for 5 years, with no interest growth, after five years you’ve got £5,000 i.e. that’s what happens if you hide it under the mattress.
However put the same £1,000 every year for 5 years into a pension fund. An interest growth of 5% a year turns it into £5,801.
This is because at 5% growth £1000 becomes £1,050 after the first year. Add the next £1,000 = £2,050.
This, increased by 5% again, in the second year becomes £2,152.5 and so on. (See Table 4 below).
So after 5 years you have £5,801, an increase of £801 on hiding it under the mattress.
Compound interest example (Table 4)
|Year No||Amount Saved||C/f||at 5% Interest growth Rate|
At year 10 you would have £13,207, an increase of £3,207 on hiding it under the mattress.
If the interest rate growth is 7% a year you would have £6,153 after 5 years, £14,784 after 10 years and £43,865 after 20 years (compared with £20,000 under the mattress).
If the interest rate growth is 9% a year you would have £6,523 after 5 years, £16,560 after 10 years and £55,765 after 20 years (compared with £20,000 under the mattress).
Perhaps more realistically for someone saving for a pension: If you are saving £3,000 gross pa and the interest rate is 7%, then by the fifth year your fund would total £18,459.
That’s at a net cost to you of £9,000 (assuming you’re a 40% taxpayer).
By year 10 your fund is worth £44,351 at a net cost to you of £18,000.
By year 20 your fund is worth £131,596 at a net cost to you of £36,000.
By year 30 your fund is worth £303,219 at a net cost to you of £54,000.
The longer you have money in your pension fund the more compound interest will increase it. (This is another good reason to avoid
front-end loaded charges).
Check the Savings Calculator to see the benefits compound interest could bring you by comparing it with your planned yearly savings multiplied by your years to retirement.
For example: You save £100 a month for 30 years = £36,000. However at 5% growth a year the same saving would give you over £83,000, and so on.
These figures may look exciting but you may want to note, (for what it’s worth now), that compound interest demonstrations were a favourite sales trick that helped entice people away from their occupational pensions into personal pensions and helped lead to the major pensions selling scandal. Though, we hasten to add, compound interest is not a trick, it really does work.