When it comes to saving for retirement, two things can significantly boost your pension pot: compound interest and regular contributions throughout your working life.
Together, these two things can form the basis of long-term financial growth, helping you close the gap between your current pension savings and the amount you’ll need for a comfortable retirement.
How compound interest works
Compound interest is earning interest on both the amount you contribute to your savings plus the interest accumulated over time. This creates a snowball effect where your pension pot could grow exponentially, especially the longer you can leave it invested.
The key to getting the most from this benefit is starting early, as even small, regular contributions can grow significantly over time due to this compounding effect – so, if you can, start saving into your pension as soon as you start working!
For example, if you start saving £200 per month into your pension at age 25 with a 5% annual growth rate, your pot could be worth over £250,000 by age 65. Waiting 10 years until 35 to start making the same £200 contributions to your pension could leave you with £140,000 at retirement – £110,000 less.
The importance of regular contributions
Making regular contributions to your pension, whether through your workplace or personal pension, is so important.
Consistent saving allows you to benefit from pound-cost averaging, which spreads the risk of investing over time and helps you build your pension.
Additionally, many employers offer contribution matching, for example, if you pay in 8% then your employer will match it and also pay in 8%. It’s usually worthwhile to contribute the maximum amount they will match. This combined with tax relief can really boost your regular pension contributions and could make a huge difference in the future.
The retirement income gap
There’s a growing concern about the gap between the pension savings that most people in the UK have and the amount required for a comfortable retirement. This difference is often referred to as the retirement income gap, and it highlights the stark difference between people’s retirement expectations and the reality their pension can afford them.
According to the Retirement Living Standards set by the Pensions and Lifetime Savings Association, there are three levels of retirement living: minimum, moderate, and comfortable. For each one, there’s an estimated annual income required to meet that standard:
– Minimum: This covers essential needs, such as housing, food, and bills. For a single person, this standard requires around £14,400 per year, while a couple would need £22,400 annually.
– Moderate: For a moderate lifestyle, including items like a holiday each year, social activities, and perhaps a second-hand car, a single person would need around £31,300 annually, and a couple would need £43,100.
– Comfortable: A single person would need £43,100 annually for a comfortable retirement, and a couple would require £59,000. This standard covers luxuries such as long-haul holidays, a new car every few years, and regular leisure activities.
Many pension savers will find themselves below even the minimum requirements. The average pension pot for someone nearing retirement is often much lower than the amount needed for a moderate or comfortable retirement.
A pot of £100,000, for example, could give you roughly £5,000 to £7,000 a year in retirement, which, when combined with the full State Pension, would give you just over the minimum living standard amount and well below the £31,300 needed for a moderate retirement.
This shortfall means that many individuals will face the prospect of a reduced quality of life in retirement unless they act to increase their pension savings now or plan to greatly reduce their living costs in retirement.
How much should you save for retirement?
To avoid falling into the retirement income gap yourself, it’s important to start retirement planning as soon as possible (even if you’re decades away from retirement!).
But how much should you save? The answer depends on a few things, including when you start saving, your desired retirement lifestyle and your planned retirement age.
A rule of thumb is that you should aim to save around 15% of your annual income into your pension from an early age. If you start saving later in life, you may need to increase this percentage to catch up. Let’s look at an example of what pension pot you would need for a comfortable retirement:
For a comfortable retirement, a single person would need £43,000 per year. And that means you’d need a pension pot of around £650,000 when you retire and to receive the full state pension.
To save for this level of retirement, here’s how much a woman would need to contribute per month, depending on the age she starts:
– If you start at age 25: around £370 per month.
– If you start at age 35: around £640 per month.
– If you start at age 45: around £1,200 per month.
This shows the significant impact of starting early and contributing regularly. Someone who starts a pension at 25 vs someone who starts at 55 will contribute 54% less and could end up with the same size pension pot at retirement!
The earlier you begin, the less pressure there is to contribute large amounts later in life. Compound interest could allow your money to grow at a faster rate, so even modest contributions can grow into a sizable pension pot over time.
Taking these steps can help you boost your pension savings and move closer to your desired retirement lifestyle – so remember to review your pension and your contributions regularly and check you’re on track.
You can also discover the full potential of your retirement savings with our pension. With us you’ll get an expertly managed pension portfolio, matched to you based on your risk profile and financial situation, so you can focus on what matters most in life.
Carina Chambers, Pension Expert: Carina has a clear focus – to help people with their pensions and to give them a better financial future. For the last 5 years, she’s focused on making pensions more engaging and accessible with clear, straightforward guidance.
As with all investing, your capital is at risk. The value of your portfolio with Moneyfarm can go down as well as up and you may get back less than you invest. A pension may not be right for everyone. Tax treatment depends on your individual circumstances and may be subject to change in the future. If you are unsure if a pension is right for you, please seek financial advice.
*As with all investing, financial instruments involve inherent risks, including loss of capital, market fluctuations and liquidity risk. Past performance is no guarantee of future results. It is important to consider your risk tolerance and investment objectives before proceeding.
