A common reaction among my peers to the slow-motion car-crash that is the pensions crisis is: “We’re gonna have to work ’til we’re dead anyway.”
It’s a fatalistic, short-sighted, shoulder-shrugging attitude that translates as: “I’m not saving enough for my pension and I’m going to put off doing anything about it by pretending I can’t do anything about it.”
But of course there’s plenty we can do about it, and it only takes a quick play with a compound interest calculator to see that delay does nothing but make the problem worse.
Compound interest and time are the nitro and glycerin of personal finance. Except it’s a friendly explosion.
It’s well known that compound interest can turbo-boost your fortune. Initially the effect of earning interest on interest is small – almost invisible – but over time it accelerates dramatically.
To maximize the miracle grow power of compound interest, it’s important to understand the major components that influence the effect:
- Time: The longer you can wait before you spend the money, the bigger the snowball effect of compounding.
- Interest rate: A small difference in the amount you earn makes a big difference over the long term.
- Tax and other costs: The less tax is clipped off your interest (or the longer you can defer the day of reckoning with the taxman) the more your returns will have had a chance to compound.
- Frequency of compounding: The more often interest is paid (such as quarterly or monthly), the quicker the compounding effect can get to work.
Time is the critical factor
Compound interest can do much of the heavy lifting towards your financial goals, if given enough time.
The Monevator millionaire calculator illustrates the point by showing how much you need to save every year to earn a million by age 65. 1
- If you harness the power of compound interest from age 20 then you only need to save £2,581 per year to hit the target, assuming an annual average interest rate of 8%.
- A 30-year old who starts saving at the same rate ends up with less than half the amount by 65: £480,329.
- A 40-year old is left wondering where all the time went, getting only a fifth of the way to a million by 65: £203,781.
Here’s how much our 20-, 30- and 40-somethings would have to put away every year to earn a million at 65:
| Age | Amount saved p.a. | Interest rate |
| 20 | £2,581 | 8% |
| 30 | £5,770 | 8% |
| 40 | £13,494 | 8% |
The differences are horrendous. Delay for 10 years and you must save at over twice the rate. Wait 20 years and you’re looking at saving more than five times the amount of a 20-year old.
Make your child a millionaire: If you’re expecting kids any time soon, you could make your child a millionaire by age 65 by unleashing the power of compound interest. Start investing for your kids from day one and if you earn an average annual interest rate of 8%, then tucking away just £1.48 a day will do the trick. Not a bad present in these days of pension insecurity. Just make sure they can’t get their mitts on the moolah a day earlier!
The interest rate matters
Seemingly small changes in the interest rate can have a profound impact on your final result. See how much less our protagonists need to save if we up the average annual interest rate to 10%.
| Age | Amount saved p.a. | Interest rate |
| 20 | £1,389 | 10% |
| 30 | £3,676 | 10% |
| 40 | £10,066 | 10% |
Our 20-year old would-be-millionaire can save nearly 50% less per year by earning 2% more than in our previous example.
Stretching for yield works less well (and is considerably more dangerous) for the 40-year old, who can only reduce his annual saving amounts by around 25%, given the shorter time he has left.
Don’t sell yourself short
In contrast, things look considerably less sunny if we drop the average annual interest rate to 6%.
| Age | Amount saved p.a. | Interest rate |
| 20 | £4,679 | 6% |
| 30 | £8,894 | 6% |
| 40 | £17,900 | 6% |
A 20-something investor earning 6% must save 81% more than a 20-something who earns 8%. With less interest to compound over the decades our young investor must increase their annual commitment, if they want to achieve the same financial goal in the same amount of time on the lower interest rate.
Meanwhile, our tardy 40-year old must find an extra 33% at 6%, in comparison to 8%.
The message is that it can pay to invest aggressively if you’re young and you can handle the risk. Sitting in low-yielding assets like cash or bonds is likely to cost you over the long run.
The historical return rate of the UK stock market is around 5% before inflation (add on about another 3% for that) while cash and gilts have brought in about 1%.
If you’re young then you have the time to hopefully take advantage of the peaks and ride out the troughs that come with an aggressive asset allocation tilted towards equities.
The table above also shows why you must guard against other assailants trying to mug your returns, such as the taxman and the expensive fund manager.
Make sure your money is tax-shielded in ISAs and pensions, and that you use low-cost index trackers so that the power of compounding has as much interest, dividends and capital gain to work with as possible.
The takeaways
- Don’t think that investing for the future can wait until later. The early years count. Start saving something now and do it regularly. The longer your investments have time to grow, the greater the power of compound interest to make you money.
- Be patient and think long term. Leave the money alone. Reinvest all your gains. The effect of compounding is miniscule at first and may seem agonisingly pointless. The most dramatic effects occur in the later years, but you’ll be grateful for them and will thank your younger self for your foresight.
- It’s never too late. You may have lost years to procrastination, financial naivety or whatever else – I know I did. But here’s a brilliant quote about letting go of the past:
The best time to plant a tree is 20 years ago. The second best time is now.
Forget about yesterday, and do something about tomorrow.
Take it steady,
The Accumulator
- I’m not saying you need a pension of a million pounds. I’m simply using the figure to illustrate that compound interest can make the seemingly unachievable achievable.[↩]
Good reads from around the Web.
One reason I’m still blogging about investing eight years after I began is because I keep learning new stuff even while trying to explain what I think I already know.
But another reason is because it reminds me of what I actually do already know.
Investing is not like electronic music or frontier physics – you don’t need to keep reinventing the wheel.
But you do need to remember that you don’t need to keep reinventing the wheel.
Sticking to a few stratagems will get you a long way, as Darrow Kirkpatrick explains in his short course on investing:
You can commit a large chunk of your life to becoming a better investor, if you want.
You can read articles, devour books, and enroll in classes. Some people, myself included, will take that full plunge.
But in the end, most experienced investors arrive back where they started, with just a few simple principles in hand.
His post quotes me alongside the likes of Warren Buffett and Harry Markowitz, so Darrow clearly isn’t infallible. 😉
But his short course is well worth the price of admission – a cup of tea, and ten minutes of your time.
And while we’re doing homework (or ‘revising’ for most of us, I hope) your next stop could be Michael Batnick’s clear overview of how to think about long-term returns.
Why? Because, as Batnick writes:
Past performance is absolutely not predictive of future results.
Data can be manipulated!
Sticking with an investment plan during a bad year (or a series of bad years) is what will make them successful.
The results of diversification are predictable even if the results of an investment are not.
His full refresher is at Enterprising Investor.
I read an article on dividend growth in the US, and asked an income fund manager contact for his view from a UK perspective, which follows. (He’s ended up posting anonymously to save all the bother of not doing so.)
Capita has just published its latest analysis of the dividends that have been paid out by UK companies.
It found that third quarter dividend payments were at a record high.
See Capita’s graph, above right, and note it’s the green bars that show how regular dividends have grown.
Capita also warns, however, that the growth of distributions is slowing, and that dividend cover is shrinking.
Many people put a lot of faith in dividends and rightly so, but that should not mean our love is blind.
Dividends, like lots of numbers in finance, are both a target and a measure. They provide income and, if reinvested, contribute to capital growth.
They can also tell us how healthy – or not – companies are.
Dividends bounced back
The graph below (derived from Bloomberg’s collation of forecasts from analysts) shows the amount of cash that UK companies expect to pay out as dividends one year ahead (excluding special dividends) relative to a UK market capitalization-weighted index:
Two things stand out.
One is the sickening lurch downwards in 2009. This came as the big UK banks discovered that they hadn’t actually earned any money from all their clever traders, PPI salesmen, and borrowers, and so could not pay it out as dividends.
The second feature is the overall rise in distributions since the trough of 2009 to the peak earlier this year.
This rise in payments – from £59 billion in 2007 to over £91 billion in 2014 – has underpinned much of the recovery in the stock market since March 2009, which you can see in the red line.
The desire for yield is a powerful motivation in a near-zero interest rate world.
What goes up…
Recently, however, the trend is downwards.
Expectations are that dividends next year will be about £87 billion, notably lower than the £91.7 billion predicted as recently as April.
There have been some high profile cuts already, the two biggest being Standard Chartered and Glencore.
We learned last year that Tesco would cut its payments, too.
On top of that there is a background of profit warnings from a lots of smaller companies that have been hit by lower growth rates in China, a slightly stronger pound, and what’s simply a super competitive environment in the UK where the lack of inflation makes it difficult to raise prices and margins.
Down with dividends
Every data analyst knows that correlation is not causation.
Nevertheless, if the market had not risen as dividends did, its yield would be 50% greater than the current figure of 3.7%. That would make it even more attractive against gilts yielding less than 2%.
This suggests the increase we’ve seen in capital values has been warranted.
Everyone likes the warm feeling generated by rising capital values but we should not ignore the slower, tortoise-like returns from reinvesting dividends.
What we really don’t like is a sudden suspension as happened with Tesco, where investors faced the double whammy of falling capital values and lower income.
At least the slow motion car crash in the commodity sector has been a warning to investors that its dividends were under threat.
When Glencore succumbed to the inevitable, its cut and associated fund raising was not a total surprise. A yield of 11% on Anglo American indicates investors have similar fears there, too.
There are doubtless many more companies where directors are maintaining distributions in the hope that this positive ‘signal’ overwhelms the few nerds who actually look at the cash flow statement and question dividend sustainability.
The Financial Times quotes the current dividend cover for the FTSE All-Share Index at 1.59 but I don’t have a figure for the projected dividend cover.
Even if I did I probably wouldn’t believe it because so many executives are remunerated with share options based on adjusted earnings per share figures.
In my opinion, these are fantasy figures to make bosses richer.
Dividends, by contrast, are real numbers backed by cash, to makes shareholder richer.
That is why they tend to rise more slowly.
No need to panic
Low dividend cover and falling dividends are big red flags hanging over this market.
Does that mean sell?
Not to it doesn’t. But it does mean we have probably reached the end of this business cycle.
So what? Another one will start soon and the process can begin all over again. Then the question will be when to buy.
Why risk getting two decisions wrong when the alternative is to sit tight, stay invested, and let those dividends you still receive after the cuts do the heavy lifting by reinvesting your income through the bottom of the cycle?
That way you will be fully invested at the start of the next upturn.
Perfect!
Good reads from around the Web.
Despite protesting that my allergy to office life meant I was the last person they should be asking, I found myself given career advice to young people this week.
They were all inspiring, even in their silliness, and it would make for good blog fodder (and I’m sure they felt the same, though sarcastic Twitter hashtags might be more their style. Alas I don’t think I am Instagram worthy.)
One of my top suggestions is to try to not to want to do something everyone else wants to do, but instead find something you like or even love doing – and that preferably you’re good at – that everyone else hates.
This isn’t always a route to riches or satisfaction (just ask a lavatory cleaner on the minimum wage) but I think it’s a better starting point than joining the other 50,000 hopefuls heading off to study fashion, photography, or marine biology.
Friends from my previous professional life look at me like I’m a dog they know has to be put down when I tell them what I’m doing these days.
Me? I can’t believe I’m getting paid for it.
Webb of intrigue
In some small way, I try to follow this principle with Monevator.
I believe most people should invest passively but I have little passion for the details, which is why we’re all lucky to have The Accumulator doing the heavy lifting. Same deal with The Greybeard and pensions and deaccumulation.
That leaves me free to wax lyrical about the philosophical aspects of investing and financial independence, and to write the occasional article about some lunatic active investing experiment that you probably shouldn’t try at home.
In a similar vein, if I had an unlimited budget then FT columnist and MoneyWeek editor Merryn Somerset Webb would be my go-to writer on debunking the intersect between financial hype and the official line, especially when it comes to government policy.
For instance, reader David pointed me towards the great job Merryn did in the FT this week with the flat rate pension top-ups being loudly trumpeted across the press as super-cheap annuities.
I’d already decided that my mum would probably be better off holding on to her cash as opposed to topping up and doubling down on living into her late 90s, but Merryn went wider [search result]:
The key here is that if you have £22,250 sitting around it is capital. Capital on which no tax is due.
If you turn it into state pension it becomes income. Income subject to income tax.
So let’s say you are a 65-year-old male 20 per cent taxpayer. You hand over the cash for £25 extra a week. With no tax it would take 17 years for the state to return to you the money that was yours anyway (£22,250/£1,300). You’ll need to live to 82 to break even.
At 20 per cent it is 21 years (breaking even at 86). At 45 per cent it is nearly 30 years (95).
Not looking such a good deal now, is it? More like a totally rubbish one (unless you happen to be married to someone who might live 20-odd years longer than you and keep trousering the 50 per cent payout).
The truth is that even if you can’t make a post-tax return greater than inflation on keeping your capital in the bank account, hanging on to your capital (and putting it into an Isa as and when you can) has got to be a better bet for taxpayers than turning it into income.
This isn’t to say these top-ups (or Class 3a Voluntary National Insurance Contributions) aren’t a good deal for anyone. I’m sure they are for some.
But it is to confess that you’re never going to find out from me.
For a throwaway remark, it’s achieved remarkable longevity. Indeed, when his obituary is written, no doubt former Lib Dem pensions minister Steve Webb’s off-the-cuff observation about Lamborghinis will once again be taken out for a spin.
That said, the 2015 pension freedoms have surely impelled some people to withdraw the lot from their pension pot and buy a Lamborghini – or if not a Lamborghini, then perhaps a speedboat, yacht or similar indulgence.
The Association of British Insurers, for instance, reckons that pension savers withdrew £2.4bn from pension pots in the first three months of the new pensions freedoms, although a survey by insurer Royal London found that most were intent on sticking the money in a bank or building society ISA account, or paying off debts or a mortgage.
On the other hand, the average size of the pension pots withdrawn by Royal London customers was just over £14,000.
That won’t buy much of a Lamborghini, anyway.
There’s always the State to fall back on…
Might Mr Webb have been wrong when he famously said that the government was “relaxed” about how people spent their retirement savings?
Given the passage of time – and bearing in mind that some Monevator readers, just like your humble scribe, are memory-wise no longer in the first flush of youth – it’s worth reminding ourselves of his words:
“One of the reasons we can be more relaxed about how people use their own money – and as a Liberal Democrat I want to give people those sorts of freedoms – is that with the State Pension coming in, the State Pension takes people above those sorts of means tests.
So actually, if people do get a Lamborghini and end up on the State Pension, the State is much less concerned about that, and that is their choice.”
In other words, elderly people will always have a safety net to fall back on, even if they spend the majority of their savings.
…or perhaps there isn’t
Yet if the government was relaxed back in 2014 about retirees winding up on State benefits after blowing their savings on sports cars, it seems less sanguine now.
In fact, a paper put out by the Department of Work & Pensions in March – which appears to have had remarkably little press coverage – makes it very clear that the government reserves the right to review how individual retirees have treated their pension savings in any subsequent consideration of those retirees’ eligibility for State benefits.
In doing so, it is aligning itself with the more widely-known ‘deprivation of assets’ test that local authorities can apply when evaluating individuals’ eligibility for local authority-funded care home provision.
So here’s what the Department of Work & Pensions actually has to say on the Lamborghini issue, in a factsheet entitled Pension flexibilities and DWP benefits:
Deprivation rule: If you spend, transfer or give away any money that you take from your pension pot, [the] DWP will consider whether you have deliberately deprived yourself of that money in order to secure (or increase) your entitlement to benefits.
If it is decided that you have deliberately deprived yourself, you will be treated as still having that money, and it will be taken into account as income or capital when your benefit entitlement is worked out.
Maybe buying that Lamborghini isn’t such a smart move, after all.
Canny Scots
Savings and ISA provider Scottish Friendly, to its credit, is at least sounding a warning about the deprivation of assets pitfall.
“There’s a misconception that if an individual cashes in their pension and proceeds to spend it in its entirety, they will at least be able to fall back on the safety net of a State Pension – but this is not the case,” says Calum Bennie, a savings spokesperson at Scottish Friendly.
“The ‘Deprivation of Capital’ rule means that if you simply spend your retirement fund, give it away or lose all of your money and end up needing to rely on the State for support, you will only be allowed to do so if the Government agrees with your financial decisions.
“The Government is trying to protect the taxpayer from having to pay twice to support pensioners who misuse their pension pot, but it remains unclear how the DWP will identify what will and will not be accepted as depriving yourself of capital and it gives no guidance as to how people will be allowed to spend their pensions.”
Problems ahead
To me, there are three issues with this.
First, that while Mr Webb’s ‘Lamborghini’ remark has sunk into the popular consciousness, the reality of the rule regarding deprivation of capital is much less widely known. Buy that retirement toy at your peril.
Second, there’s the potential for well-meaning but unlucky, unfortunate, or simply naïve retirees to be retrospectively caught out by this.
Suppose that in all good faith, someone withdraws their savings and places them in whatever is tomorrow’s equivalent of Barlow Clowes, spilt-capital trusts, or Bernie Madoff’s Ponzi fund. At which point, a spotty oik down the local DWP office reduces their entitlement to State benefits, saying that they’ve been reckless.
Clarity about what exactly counts as ‘deprivation of assets’ is sorely needed.
Thirdly, the government itself is guilty of double counting, here. Withdraw a Lamborghini-sized sum of money from your pension, and you’ll promptly pay a large dollop of it in tax, potentially at your highest marginal rate. Yet the Department of Work & Pensions, in its own words, intends to treat you as though you still possessed that full, gross, amount—rather than the amount after tax.
Reader reaction
So what’s your take on it all, dear reader?
Comments, as usual, are welcome – so feel free to make a knowledge contribution to the wider Monevator community.
But please don’t forget that I’m not a ‘pension professional’, but simply an ordinary private pension investor, just like you. So I won’t respond to intemperate attacks, or posters with a penchant for elaborate ambushes.
Let’s all just try to educate each other.
- Read more of The Greybeard’s articles on pensions and deaccumulation.
