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The power of compound interest

Annabel Fay
Monday 16th December, 2019

The world is changing. High costs of living, the gig economy, flexible working and zero-hour contracts mean it isn’t always easy to make ends meet, let alone to save. I know this better than anyone- as a self-employed freelancer, I left my corporate job and had ‘sort out savings’ on my to-do list for 3 months. 

Here’s a fact to ponder over your avocado toast: 

32% of people have less than £500 in savings, and 41% have less than £1,000. In fact, more than half of 22 to 29 year-olds say they have no savings at all

I don’t know about you, but I think that fact is kinda terrifying!

It’s an amazing thing: more and more people are breaking free of the traditional corporate job. 

Working for yourself means you take advantage of the flexibility to work remotely (hello, Thailand!) or on projects that excite you or fit with your values. Want to start a goat-yoga franchise? Good for you. In fact, over the last 13 years, the number of people reporting themselves as self-employed in the UK has increased by over 40%. 🐐

But while Starbucks is reaping the rewards, unfortunately, self-employed people are wary of saving or investing in a pension. I know I was. 

When you work for yourself, your income can vary widely from one month to the next – the thought of regularly stashing away money into a pot that can only be tapped into decades down the line does not sound very appealing. Especially when we’re bombarded with news of political turmoil and global warming- it’s hard to imagine a future right now. 

However, even though the future is uncertain, the 5 million self-employed people in the UK are likely to face a financial crisis when the wrinkles set in. Even though traditional pension solutions are unnecessarily complicated and confusing, they’re really powerful- particularly when entered into early to take advantage of compounding. 

It’s not as boring as it sounds, I promise! In fact, it’s kind of magical. 

What is compound interest?

Put simply, compound interest occurs when the interest that accrues to an amount of money in turn accrues interest itself.

Annabel, I haven’t had enough coffee...what?

Let’s start with an example. 

If you save £100 in a pension pot, and over the course of a year that £100 gains 4% in interest. (My editor told me to tell you that’s a projection based on historical performance, capital is at risk, and generally in money, as in life, there are no guarantees. Thanks, Pete.)

Anyway, 4% additional means at the end of the year, you have £104. Wahoo! 

The following year, your pension grows another 4%. But this doesn’t just apply to your original £100, it applies to the whole pot- meaning you gain 4% on £104. So you finish year two with £108.16. 

It doesn’t seem a lot, but if you apply this idea to the magic ingredient, time, it really adds up. Even if you never add anything to this pot ever again, in 25 years time that pot is worth £266. It has almost tripled in size, without you doing anything at all. 

If you carried on adding £100 a year for 25 years, adding £2500, when you take it out your pension would be worth £4500- nearly double what you put in. That’s a lot of free money. 

They say there’s no such thing as a free lunch- well, that’s not true- compound interest is a lot of free lunches. 

Well, you’d hope to be able to save regularly, right?

Let’s take an example with somebody making regular contributions to their pension, starting at age 30. The earlier the better- the longer the money is in there untouched, the longer magical compound interest has to work. 

Person A- Let’s call her Abby, has £5000 in savings. She makes a £250 contribution to her pension pot every month and leaves it in there for 25 years.

Compount interest graph example

When she comes to take the money out, compound interest has increased her contributions from the £75,000 she saved to a total value of £143,000. Woah- that’s almost double! When we’re dealing with bigger numbers, that’s suddenly a big difference. 

Person B, let’s call him Ben, starts a bit younger than Abby, and he’s able to save £250 a month for 35 years. At the time he wants to retire, his £100,000 saving has become £249,000.  

Blimey, Ben, time to book a cruise.  🚢

Compound interest graph example

But what if I can’t save consistently?

We know self-employment is hard. Sometimes you’ll have lots of cash come in, sometimes it will be beans on toast for a few weeks. Some days I start with beans on toast and then I win a client or someone finally pays me and I finish with a fancy dinner. #livingthedream. 

Anyway, at Penfold they’ve made it easy to top up your pension as a one-off when you have money, and lower or stop your regular payment when you don’t.

Even if you can’t save regularly like Abby and Ben, leaving your savings pot without contributing still takes advantage of compound interest. 

Seems crazy- but with compound interest, the most important thing is to open a pot and leave it as long as physically possible- until you can’t put off that blue rinse any longer. Topping it up regularly is best, sporadically is good, but the most important thing is to have the pot. 

Remember- pensions are the best way to capitalise on compound interest because pensions are long term, which maximises the potential gains. They’re also pretty darn good for hiding money from the taxman. (Yes, ok, Pete, we’re not actually advocating hiding money- they are tax-efficient though! Editors, man.) 

Flexible pensions for the self-employed

As I said, it’s amazing seeing the entrepreneur spirit in the UK right now. Some days I can’t get my flat white past the sea of laptops. I’d love to know what they’re all doing! 

The Office for National Statistics (ONS) reported recently that:

A fifth of 16 to 21-year-olds say it’s likely they’ll be self-employed at some point, and 10% of 22 to 30-year-olds are working for themselves after leaving education.

There are huge benefits to being self-employed. Answer to yourself, work flexibly, not have to go to awful annual holiday parties or remember how everyone takes their tea- but also some downsides. 

Auto-enrollment into pensions is one of them. 

When the government brought in auto-enrollment in 2008, it meant that every employer in the UK must put certain staff into a workplace pension scheme and contribute towards it. So if you joined a ‘normal’ job with more employees than just you and your cat, you got put into a pension, and your employer put some cash in too. 

The results were staggering- the amount of UK workers in a pension scheme jumped up to 87% in 2019, from 55% in 2012. Auto-enrollment is going a long way to help the UK deal with an underprepared ageing population- at least for those in a traditional job. 

However, for the rest of us, being self-employed and changing job all the time is leaving a gap. If you’ve taken a look at how much state pension you get, it’s definitely no longer enough to live on. At least global warming will help the energy bills.

What I’m saying is this stuff is really important. Save for retirement so you can actually retire someday, get a nice tax break, and get free money from compound interest. 

At Penfold, we’ve decided to make it a whole lot easier by offering a technology solution. Honestly, no need to waste more trees. It takes less than five minutes to set up a pension online – and there’s minimum jargon.

Often, starting is the most difficult step.

Register for a Penfold account now.

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