Albert Einstein was once quoted to have said “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it”.
Whether you believe Einstein said this – or that compound interest can be as awe-inspiring as the Taj Mahal – is up for debate! But the concept is most certainly true.
Compounding is where your investment growth – or interest – is reinvested to generate more growth. Your investment then grows not only from your initial investment, but also from the interest accumulated over time. Basically, you are generating interest on your interest!
To see this in practice, let's imagine two people investing into their pension, Alexis and David…
They both pay £2,500 into their pension every year. Let’s assume their pension portfolios grow at a 7% growth rate per year.
Alexis decided to make her contributions as soon as she started working at 21 and until she left work at 30 years of age. The total amount she invested in her pension was £25,000. She then decided to break free from the corporate world, pack a suitcase and travel the world, forgetting all about her pension until she needs it which, she thinks, will be at about 70.
David, on the other hand, didn’t think about paying into a pension until he got to 31! He then started paying in £2,500 per year, the same as Alexis, but over a much longer time, in fact, over the next 40 years. The total amount he invested in his pension was £100,000 and he, like Alexis, is looking forward to retiring at about 70.
So… who has the bigger pension?
Were you thinking David? You’d be wrong, it is in fact Alexis! How is this possible?
Even though David invested more into his pension, he didn’t have as long to earn ‘interest on interest’, but still made five times as much – or a 5-fold return – on his initial investment, valued at £534,000.
Alexis, however, made 22 times as much – or a 22-fold return – on her initial investment due to compounding, giving her a portfolio valued at £553,000.
Now, financial advisers won’t be advocating for Alexis’ grand plan of travelling the world and forgetting to invest in her pension (think of what her portfolio would have been worth if she did!), but it demonstrates how ‘interest on interest’ really does add up.
Do something brilliant with your pension!
Your pension can be driven and influenced by your own beliefs and intentions for the future, so it should no longer be seen as something that’s simply deducted from your monthly pay, with an annual statement that barely gets a glance. This is your long-term investment that you can have ownership of and interaction with.
Give some thought into how much you can afford to invest in your pension for the long-term – be more Alexis, and less David! There are many benefits for doing so e.g., tax relief, and of course, the security you will have when you decide it’s time to retire.
For more insights on how to manage your pension – and indeed your investment journey – why not subscribe to the She-Wolf investor podcast. You might especially enjoy our latest episode – Pensions with Intentions.