Compounding is a powerful way to give your savings a boost over time. It can grow a savings pot of any size, even when left untouched. Take a look as we unpack what compounding is, why it matters and how it helps you grow long-term investments like your pension.
What is compound interest?
When you put money in a savings account at a bank, the bank will pay you interest on the original amount of money you put in after a set period of time, like 12 months. Compound interest is simply the interest the bank will pay on top of your original amount and any interest it’s already earned combined.
“The Compound Effect is the principle of reaping huge rewards from a series of small, smart choices.” ― Darren Hardy, Author of The Compound Effect
Time - compounding’s magic ingredient
The longer you leave your money in an account that earns compound interest, the more time it has to grow. It’s a force multiplier that builds on previous years’ investment growth.
This often means considering carefully before deciding to take any money out of an account that earns interest. Not simply because there may be a penalty for early withdrawal but because it could lose out on that growth opportunity in the long term.
How compound interest works
Let’s look at a quick example. Say you invest £1,000 at a 5% annual interest rate. If the interest compounds annually, here’s what it could look like over a few years:
- after one year: £1,000 grows to £1,050;
- after two years that £1,050 would grow to £1,102;
- after three years that £1,102 would grow to £1,158.
The numbers might seem modest at first, but as the years go by, the growth becomes more dramatic. So, after 10 years you could earn an additional £628 without having to touch your initial savings.
Compounding can grow your pension pot
Compound interest can be highly beneficial for pension savers. Here are some ways you can take advantage of the power of compounding to grow your pension pot.
Start early - the sooner you begin saving into your pension, the more you can benefit from compounding over time. In a pension, compound interest works by reinvesting any interest earned back into your pot. Keeping it reinvested, allows it to grow as well as potentially benefit from long-term returns on your plan’s performance.
Contribute regularly - even small, consistent contributions can lead to significant growth in the long run. As the example above shows, your savings can benefit from compounding even if you don’t add any more to them. It’s worth investing what little you can.
Be patient - pensions are long-term investments by design so they can be allowed to grow over time. In fact, you can’t even access a pension before 55 (rising to 57 in 2028) without paying a tax penalty. This can give your pension several decades to take advantage of compounding.
Consider delaying withdrawing - the more money you leave in your pension, the more of it there is to earn interest on. Of course, you’ll want to start taking your pension eventually but holding off as long as you can, or taking smaller amounts could continue benefiting your pot size. Read more reasons to consider delaying taking your pension.
Remember other pension benefits - combine the power of compounding with pensions’ other unique benefits like tax relief. Most UK taxpayers usually get tax relief on their personal pension contributions, which means that the government effectively adds money to your pension pot. Most basic rate taxpayers usually get a 25% tax top up; HMRC adds £25 for every £100 you pay into your pension making it £125.
If you’re enrolled in a workplace pension scheme your employer has to contribute to your pension too. The minimum employee contribution is currently set at 5% of your ‘qualifying earnings’, while the minimum amount your employer has to pay is 3%.
Key takeaways:
We hope you see the power of compounding to help grow your pension. Here are three key things to remember:
- Compound interest is interest paid on money you’ve saved and any interest it’s already earned on that original amount.
- It’s most effective when you leave your money untouched so it can grow. Ideal for a long-term investment like a pension.
- Saving whatever you can as often as you can into your pension will help take advantage of compounding.
Risk warning
As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.
