Why start your pension early?
The most common pension mistake is waiting too long before starting one. Perhaps you think you can’t spare the money, or you think you have plenty of time later – or you simply don’t want to think about getting old.
But the very best time to start a pension is when you are young. It doesn’t matter if you can afford only very small payments into it at this stage – you can increase your payments later as your income rises. The power of compound interest over time means that even small savings early on can be more important than larger savings later.
The effect of compound interest on your pension pot
Consider two pension savers, Eloise and Harry. Eloise starts her pension at the age of 20, investing just £50 a month. Harry waits until he is 40, but invests £100 a month.
Supposing an average interest rate of 4%, when Harry is 60 he will have a pension pot of just over £36,500. Eloise, however, at the same age will have a pension pot of nearly £60,000. Notice that the two savers have invested exactly the same amount of money over time – but because of compound interest, Eloise has ended up with nearly twice as much.
However, both pots will actually be even bigger than that – thanks to tax relief.
The pension boost from tax relief
Compound growth isn’t even the best thing about a pension. What makes them unique is the tax relief they bring. When you make a payment into a pension, the government repays you tax at the highest rate you normally pay – which effectively means you are ‘given’ extra money.
This means that, in the example above, each time Eloise pays £50 into her pension, what actually gets paid in is £62.50. This is because Eloise (a basic rate taxpayer) normally pays tax at 20 per cent, and £62.50 taxed at 20 per cent would be £50. The money arrives in the pension as if it had never been taxed.
When you take tax relief into account, Eloise's final fund will actually be over £72,800.
As for Harry, let’s suppose he is a higher rate taxpayer. He pays tax at 40 per cent, so each of his £100 payments becomes around £166. However, even with this huge advantage, he won’t quite match Eloise, as he will finish with around £60,600.
The tortoise beats the hare!
From this example, you can see that a modest earner, receiving half as much tax relief, can still end up with a bigger pension pot than a higher earner – just by starting their pension much sooner. So remember, when it comes to saving your pension, time really is money.
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