Pensions: Why it pays to start saving early

Cris Sholto Heaton explains why making an early start on saving for your retirement can make a big difference to your pension pot.

There aren't many pieces of investment advice that are simple, easy and guaranteed to work for anybody, but "start earlier and save more" is one. Surveys consistently show that it's the top tip that today's retirees would give the younger generation. Unfortunately, it's a lesson that many of us learn too late.

That's because it's easy to underestimate the difference that an early start can make to your lifetime wealth. To see why, let's consider the fate of three investors who begin saving at the age of 22, 30 and 40 respectively.

Our hypothetical investors earn the national average wage for their age in each decade of their life, consistently put aside 10% of their income once they start saving and manage a return of 6% per year after costs, taxes and inflation.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Based on these assumptions, the investor who starts saving at 22 will have total savings of around £520,000 by the ageof 65. The one who begins just eightyears later at the age of 30 will have around £345,000 one-third less. Waiting until you're 40 to make a first contribution will be even more costly, delivering a final portfolio value of just £170,000.

The gap in total wealth is vast, yet very little of this is due to younger savers paying more in contributions over their lifetime. The 22-year-old pays around £45,000 more than the 40-year-old, yet the additional wealth they gain is about £350,000.

What makes the difference is decades of compound returns on contributions made early in life. Indeed, the effect of compounding is so powerful that if the 22-year-old stopped saving at 40 and just left his existing capital invested for the next 25 years, he would still be roughly twice as wealthy at 65 as the investor who began saving for the first time at 40.

Are you saving enough?

Working out how much we need to save for our retirement depends on a number of factors, so let's make some broad assumptions:

For the amount of income we'll need every year when we retire, we assume two-thirds of our pre-retirement income. This is a standard rule of thumb in the UK and should provide a comfortable retirement for most people.

To calculate the pot we'll need to get this, we need to use a "safe withdrawal rate". That's the amount of dividend or interest income and capital gains we can take from our pot each year and still be confident we won't run out of money.

Traditionally, many financial planners used a figure of 4%, but in the current low-rate environment, that looks riskier. We'll assume 3.5%, which means that our pension fund at retirement will need to be almost 30 times our target income.

If historical investment returns are a good guide to the future, we could take 6% as our expected after-inflation return on UK stocks. That's what the market averaged between 1964 and 2013.But returns may be lower in future and that doesn't allow for costs and taxes anyway. We'll use 3% and 4.5% as more conservative scenarios as well.

Given this, we can calculate what percentage of their income an investor needs to put towards retirement each year if they start at a certain age. The table below shows approximate figures for three ages and three rates of return.

As you can see, starting early significantly reduces the amount you need to pay, because you benefit from many years of extra returns. An investor who doesn't start until they are 40 will have to contribute a very large proportion of their earnings to catch up.

The risk of low returns

And you certainly shouldn't reduce your contributions if you're already saving more than they imply. In one important respect, our assumptions may well be too optimistic.

It seems quite likely that we will see lower-than-average returns over the next decade. Unfortunately, this is largely out of our control with even the best-designed portfolio. Saving more is the best hedge against this risk.

So if you're not already saving, start now. Whatever you're currently saving, consider increasing it it will cost you less than doing so in ten years' time. And if your own retirement is secure, start thinking about your children.

The benefits of compounding are so great that a few thousand pounds contributed to a pension on their behalf while they are toddlers could be worth more by age 65 than the entire amount they pay in during their working lifetime. It's too late for us to start that young, but we can certainlyhelp them to do so.

How much should you be saving?

Swipe to scroll horizontally
Age at which you begin saving2220%15%10%
Row 1 - Cell 0 3027.50%20%15%
Row 2 - Cell 0 4045%35%30%
Calculations assume national average earnings throughout life, 3.5% safe withdrawal rate after retirement at age 65, and a target pension of two-thirds of pre-retirement income.
Cris Sholto Heaton

Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.

Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.

He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.