How does compound investing in a pension work?
Learn how compound investing works and how it can benefit your defined contribution pension.
Compounding is a powerful force when it comes to saving or investing and it works to build your wealth over the years. Imagine a snowball rolling downhill picking up snow and getting bigger and bigger all the time, the bigger the snowball gets, the more snow it collects – that’s compounding. But how does it work when it comes to investing in something like a pension? We’ll explain here.
What is meant by compound investment?
Compound investing (also known as compound interest investing) is where earnings like dividends that come from holding an investment are reinvested. If you hold shares for example, this adds to the size of your shareholding and helps your investment benefit more from any growth.
This also works for any cash you hold in your investments that are earning interest. Interest is first added to your original amount, increasing how much you hold. Then, when interest is added again it's calculated on the increased amount.
How can I benefit from compound investing?
It’s simple to benefit from compound interest, beyond choosing the right investments with good growth potential, the biggest thing you need is – time. The earlier you begin investing the more time you’ll have to benefit from the effect of compounding. That’s why people are advised to start a pension earlier in life. The difference 10 years will make can be surprising.
If you invest £10,000 at the age of 25 with a 4.5% annual return, by 65 that will become £58,000.
If you wait 10 years and start at 35, it will only grow to £37,000.
The jump in value between 40 years investing and 30 years is nearly 64%.
Investing regularly can boost the effect of compounding by adding to the initial amount you've invested. Growth, rather than Income, investments will reinvest any dividends you're paid. Growth investments are sometimes known as accumulation funds.
You should also check any fees you’re paying on your investments, using a platform or fund with high fees can cut your gains and slow down the effect of compounding.
Remember, the value of investments can fall as well as rise, and you may get back less than you’ve put in.
When should I start investing in my pension?
When you first start work, spare cash may be thin on the ground. But this is the best time to start paying into a pension. You’ll have a lot more years to benefit from compound interest, so even small amounts can make a big difference. Retirement may seem to be far away, but your future self will thank you when you’re sitting on a healthy pension pot.
Now in the UK, you’ll be auto enrolled into a workplace pension in most companies. It can be tempting to keep these contributions at the minimum, but with workplace pensions your employer will pay in too. The more you pay in, the larger this amount could be, swelling your pension effectively for nothing. Even if you’re self-employed you’ll get tax benefits from pension savings, so it’s well worth making them part of your business plan. We have more useful guides on pension saving here.
Any time you get a pay rise, the percentage you’re paying into your pension will also see a lift. But if you can spare more of this extra cash it can boost your pension payments even further. Everything you save helps boost your compounding effect.
If you haven't begun investing in a pension, unless you're very close to retirement, it's usually good to start any time. You may have to pay in more than when you were younger to build a similar pension pot, but even in your 40s and beyond you’ll still have the same tax benefits.
We have a simple pension calculator that you can use to see how much you should be saving to get the retirement you'd like.
How do pension funds work?
Pensions are often part of a larger pension fund, which brings together individual contributions and invests them as a group.
The money is put into a range of things like stocks and shares, bonds and even commercial property. These investments are chosen by a pension fund manager. They also check the performance and risk level, then makes changes to try and keep it on track. In the UK, pension funds are regulated by the government to make sure they act responsibly with their members’ contributions and have funds to pay out to retirees when the time comes.
All personal pensions and many workplace pensions are defined contribution. This means the value of your pension pot depends on your contributions, charges and the growth of your investments. Here, poor investment performance would be an issue for you.
With defined contribution pensions you should always keep an eye on the investments in your pension and that you're not paying large fees. That way you can be sure you're getting the level of growth you're aiming for and are on track for your retirement.
Pension tax benefits are based on individual circumstances and are subject to change.
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