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- the real-inflation adjusted return on equities is too low and
- you don’t live long enough and
- you don’t work long enough (sort of related to #2)
None of these are within your control.
Wealth warning – nothing in this should be construed as saying that you don’t need to save into a pension in your 20s. All I am saying is one of the common stories about early pension savings is overrated to mythical extremes. Saving enough money to stop working is a tough job and takes the whole of your working life. The sooner you start, the sooner you can check out, provided you balance pension savings with the rest of the calls on your finances.
What is compound interest?
There’s a much more positive account of it not written by a cynical old git available here, but the definition is easy:
Paddington Bear takes his money to the bank, and deposits a nice five pound note. A year later he gets £5.10. That’s because he gets paid interest on his money, of 2%p.a. Next year he gets 2% on £5.10. And so on until he is rich beyond his wildest dreams, apparently. The mathematically astute will observe that the future value of his investment is basically
Present value × (1.02) ^years in the bank
where ^ means raised to the power of. Now I’m going to cheat and raise Paddington’s interest rate to 5% for reasons that’ll be clearer later on.
And show you this chart. You will observe that if Paddington puts in £1 in 1974 and becomes a Retired Bear this year then he’ll get 45 times as much out. Fantastic. People use that sort of thing to give you bullshit like “when saving for 10 years is better than saving for 40” along with the obligatory wacky picture of Einstein, who is supposed to have said compounding is the eighth wonder of the world
Fabulous story. But it’s fiction. I’m not contesting the maths – after 30 years as an engineer I’ve learned you don’t fight the laws of maths or physics. It’s incontrovertible that if Paddington got a real interest rate of 10% every year, his first year’s saving will punch 45 times the weight of his last year’s saving. Note this graph shows only what happens to the value of his first £1, not the cumulative value of his pension!
That’s the story, but the devil is in the detail
Detail #1: Whoa, boy, you said 5%!
The sharp-eyed will, of course, spot that I said 5% at the start, in which case lower your gaze from the lofty value of 45 to the pedestrian boost of 7 times.
That’s the first problem. As I described in an earlier rant on this topic, Warren Buffett, the most successful investor the world has ever known , has managed 13% annual return in real terms. So he’s doing better than 10%.
You aren’t going to do that. You’ll get about 5% provided you can avoid screwing up, which is challenge enough in itself. Follow these ideas on passive investing and you stand a decent chance.
That’s the trouble – to make the compound interest story interesting you have to sex it up with unrealistic values of return. And it’s gotta be the real rate of return, ie subtract the long-run rate of inflation from your nominal investment return as well as any fees. The FCA regulator doesn’t even allow people to use 10% for their optimistic projection rates for equity based pension investments. Repeat after me – you are not Warren Buffet.
Detail #2: Most people earn more as they get older
at least compared to the start. If they save as a percentage of salary they will save more as they get older. I deliberately selected a chart that made a dramatic entrance, because it’s all about that first £1. You save to a pension across your entire working life. A lot of the UK PF community seem to work in finance, where this may not hold because burnout is rife in that industry; it’s a young man’s game. But most people pick up some knowledge, skills and contacts so they can command a higher salary in their 30s and 40s than in their 20s. It’s much harder to save 10% of your salary when it’s £25,000 than when it’s £50,000, because the fixed costs of living are a larger proportion of your income. There are other pressures on people in their 20s that I didn’t have in my 20s, so it’s even harder, but even I found the cost of rent, house deposits and all that stuff hard in my 20s and early 30s
These charts show you the total as a sum of all the contributions, growing. You can track how each of the contributions grew if you have the patience and clarity of eyesight. In the top one there is no career progression at all, in the second one over 40 years the Ermine achieves a 3× real times value career progression (this happened to me over 30 years, which would make the later contributions even more equal with the early ones In the first chart £1 is contributed each and every year, and compounds at 5%. In the second chart I start off contributing £1 and then each year it is increased by linearly interpolating to a final salary of 3× initial salary (ie adding £3)
You can see in the first example the early contributions punch way over their weight, but in the second this effect is deflated by the increase in salary. The favouring of later contributions is in fact much heavier due to tax breaks benefiting the better off more because –
Detail #2a: It’s easier for the rich to save and they get more bang for their buck in a pension
because they are saving 40% tax instead of 20% tax. So to save £100 in his pension a rich saver only needs to go without £60, whereas a basic rate taxpayer needs to reduce his post-tax income by £80. The fixed costs of living are usually still a lower proportion of income, so they get a win from that too
Detail #3: Can you stick working for 40 years?
Look around your office. How many 60-65-year olds are there? If people start in your company at 25 then one in 8 should be old gits between 60 and 65. If there aren’t that many it says something about the likelihood of you working there that long. Now generalise that to your industry. Note how all the compound interest action happens at the end of the chart… 1
I’m perfectly capable of engineering, still. It was the stupid gamification of the workplace and nutty management that I tired of and made me want out. Yes, maybe I was more mentally unstable or weaker than the average Brit. I don’t think it’s that huge – in my last year at work I had to rugby tackle one dude in the office who had just hurled a laptop computer at the wall, over a few colleagues’ heads because he was pissed off by something it was or wasn’t doing.
I took his car keys, drove him home, stuck him in a chair and told him to get on the horn to his doctor. ASAP. The official story was that he tripped and dropped his laptop on the stairs. Mental health wasn’t good at The Firm. There are a few cracked paving slabs under some of the stairwells. You can’t open the windows in those stairwells any more…
And it’s not good in a lot of places. We have people talking cock like this
You need Emotional Resilience.
For many people the workplace is becoming a worse experience. Some of the problems are fundamental. There is a power-shift from labour to capital which is particularly noticeable in developed economies because globalisation and improved communications dramatically increases the global workforce that can be brought to bear on solving business needs.
So about that 40 years you need to work for compound interest to give you a leg-up, well, it’s time to roll out Clint again
I didn’t bloody well make it to the modest normal retirement age of The Firm at 60. Will you? And I was lucky – after I got a job I never lost it 2 until I took voluntary redundancy at the end of my working life.
Detail #4: if your workplace is no place for old men, compound interest ain’t going to help you much
‘Cos early retirees are drawing down their savings earlier, and so they have less time in pure accumulation mode
Compound interest is oversold
I’m not saying compound interest does diddly-squat for you – in that previous rant I came to the conclusion that it would give you about a 50%-100% uplift on what you pay in over a typical working life, less if you experienced career progression and saved more towards the end, more if you very given a pension at birth by your parents. But don’t get the impression it’s going to do a lot for you, and the Telegraph article was absolute bollocks – the 10 year saving beating out 40 years only applies at unrealistic rates of return.
You can test this out yourself on Monevator’s Compound Interest calculator. An Ermine saving £100 a year for ten years at 5%p.a. gets £1500 at the end of that 10 years. The lazy tyke then sits back for the next 30, ending up with £6500 after 30 years of 5%. The Johnny-come-lately variant steadily saves £100 a year for 30 years and ends up with £7000. Who knows – the Johnny-come-lately variant might have put the £100 a year for ten years into a house deposit or starting a business, in which case it would benefit his finances in other ways. In my case the Johnny-come lately fellow earned twice to three times in real terms as the young pup, so he probably ended up with £14,000. The old boy was a 40% taxpayer too, so each £100 saved cost him £60 rather than £80. It’s just not a fair fight.
You ain’t gonna get the rates of return that the Telegraph used, and unless you’re a vampire you ain’t getting to live long enough to have compound interest do the heavy lifting for you. If you get an employer match in your 20s that will probably do as much for your early contributions than compound interest will. The Telegraph had you working for 50 years FFS – life is much too short to donate 50 years of it the The Man. Life is not all about work. My earnings, for what it’s worth, although respectable and well above the UK average were low compared to what I’d estimate to be the majority of the UK PF community – I never earned anywhere near £100,000
There’s a converse part of the story. If you are an old git in your late 40s and you suddenly find all four engines flame out in the second half of your career for some reason then compound interest does not mean you are doomed automatically. I saved a quarter of the HMRC nominal capital of my final salary pension in the last three years of working and filled ISAs and saved cash with NS&I. I was lucky enough to be standing next to an open goal in the form of the stock market when I started. And I was fortunate enough to have enough mental capacity left to seize the day.
Compound interest will do something for you. But it won’t be earth-shattering, and it’s not worth flogging yourself into the ground in your 20s for. Try and take the employer match, because it’s rude to leave part of your salary behind. But before you believe the stories about the 25-35 making more difference than the 35-65 years do the maths. With realistic, not fictional values for the rate of return.
Compound interest is particularly not going to help early retirees. I am a normal early retiree (less than 10 years to normal retirement age for my company). Very early retirement (40s) or extreme early retirement (30s) means your money only has 10-20 years to grow. Compound interest at 5% just ain’t gonna cut it, you’re own your own, which is why ERE’s logic ignores it totally.
- this is in fact a property of any autoscaled charts of that sort plotted on linear scales. If I were to extend it to a thousand years all the action would look like it happened at the end ↩
- I did switch jobs a few times. But without gaps – when I left the BBC in London on Friday I came to Suffolk and started at The Firm on Monday ↩