The best way to save for your old age

Saving for your old age is an important business. Most of us have little idea of how much we need (research from HSBC shows the average under-24-year-old thinks £50,000 will do the trick!), and those who do aren't quite sure how they are going to get the cash together.

Read the personal finance pages and you will find solutions aplenty. However, in the end it comes down to pretty simple stuff: save as much as you can for tomorrow without making a misery of today. Save it into a tax-efficient wrapper, preferably an Individual Savings Account (unless someone else is matching your pension contributions, in which case use a Self-Invested Personal Pension). Use the money to buy low-cost, sensibly run funds, preferably investment trusts which tend to have better performance records than unit trusts. Ensure you take full advantage of the miracle of compounding by reinvesting all your dividends.

This last is crucial. All studies of stockmarket returns show that the majority of returns over the long term come from collecting dividends then putting them straight back into the market. Between 1986 and 2008 the FTSE All-Share Index rose just over 200%. But the total return to the UK's dividend re-investors was630%.

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Clearly, when you open an Isa or Sipp you should tick the "reinvest dividends automatically" box; not the "hold dividend income on account" box. But there's a hitch. An email from a reader has alerted us to the fact that in many cases these two things can effectively mean the same thing.

At Hargreaves Lansdown, for example, which many MoneyWeek readers use for its excellent service and simple platform, dividends aren't reinvested immediately. Income from funds is reinvested when you have a total of £50 in income, and from shares and other investments when the amount to be reinvested hits £200. So say you hold £5,000 divided between five investment trusts, each yielding 4%, it'll be five years before your dividends are reinvested, which will somewhat dampen the miracle of compounding.

Obviously, the bigger (and/or less diversified) your holdings, the less of an issue this is. But it does mean there might be a case for asking for your dividend income to be kept on account and reinvesting yourself avoiding too many dealing fees along the way by putting it all into one fund in one trade, rather than returning each dividend to its original fund or share.

If that sounds a bore, you might have a think about what happens to your cash while it awaits automatic reinvestment: most platforms will pay a maximum interest rate of 0.25% on cash held on your account. That's not going to help much with your compounding either.