Pensions: Why it pays to start saving early

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.

Based on these assumptions, the investor who starts saving at 22 will have total savings of around £520,000 by the age of 65. The one who begins just eight years 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?

While it’s crucial to understand how much difference an early start makes, in reality most of us approach this problem from a different angle. It’s too late to start saving earlier, so what we need to know is whether we need to save more.

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

It’s important to be aware that these results are very sensitive to the assumptions we make. For example, if we increase our safe withdrawal rate, the amount we need to contribute will fall (as the same size of pot will be able to produce a bigger income). If we want a higher income, it will rise. So you should see these as illustrations, not rules.

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 certainly help them to do so.

How much should you be saving?

Expected annual rate of return 3% 4.50% 6%
Age at which you begin saving 22 20% 15% 10%
30 27.50% 20% 15%
40 45% 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.