The Magic of Compound Interest is Vastly Overrated

Albert Einstein is reckoned to have thought it the most powerful force in the universe. It’s often used to exhort young pups to stop blowing their first paycheques on sex, drugs and rock’n’roll. A Google search for “the magic of compound interest” throws up no end of sites telling you that compound interest will make the job of saving for retirement easy, if only you have the intestinal fortitude to do without when you are young. The regular meme trotted out is that Sensible Susan who saves in her pension for 10 years from 25-35 retires on more than Feckless Freddy who lives it up for 10 years before starting to save at the same percentage of salary as Susan, but from 35 to 65. The magic of compound interest is supposed to mean that Feckless Freddy will never catch up.

Wealth Warning – if you’re younger than 40 and looking to use my POV as a reason to redirect your pension contributions into beer and high living you ought to first read this eloquent description of the contrary view 😉 It is far more widely held. I didn’t have this experience, but then perhaps something is anomalous about my lifestream. Note also that I will have a working life of about 30 years, and of those years I have only experienced unemployment for the first 6 months. Your risks of spells of unemployment are probably higher, so although compound interest isn’t necessarily a reason to start young IMO, those periods of involuntary unemployment stopping you saving enough in total is.

The magic of compound interest is bull, in my opinion, and in my experience. The reason it is bull isn’t that compound interest doesn’t work. The reason is that the examples used to show the young pup that he should forego his hedonistic lifestyle and save into a pension as soon as he gets his first paycheque all assume high compounding rates.

That’s not to say you shouldn’t start early, but realistically, your early savings will pale in comparison with your later ones, and compound interest isn’t some magic fairy dust that will make up the difference. If you don’t start by the time you’re 30 it’s probably no big deal. If you don’t start by the time you’re 40 it probably is a big deal, because you’ve reduced your savings window to half your working life.

Let’s take three guys, all leaving university at 25. Let us also take the view that these guys don’t have any career progression, something that favours the compound interest advocates. They all get the average wage of £25k. Let us assume an approximate inflation adjusted return of 5% p.a. which is better than the 3% of the FTSE100 on a total return basis for the last 10 years. The FTAS isn’t much better over the same time frame. Let’s assume annuity rates are about the same at 5%, or these guys target a safe withdrawal rate of 5%.

Lucky Luke is a born idler whose Dad put £2k into a junior ISA when he was born and left it to accumulate. Presumably his family is old money that knows you never spend capital, so he resisted blowing it on a car when he was 21. Because  he lives a life of luxury and never had to work so he never added to it.

Steady Eddie starts work and works for 40 years straight through, paying into his NEST pension at the recommended rate of 8%. He retires on a pension of about half his salary at £12,600, which is fine as he’s paid his house off. Along with his pipe and slippers he gets a bunch of cruise line brochures.

Burnout Brian starts as a runner at Goldman Sachs, but can’t hack it after 10 years and drifts off to a life on the dole, so he only pays into his pension for 10 years and stops. Articles like this,  this and this lead us to believe that Burnout Brian will retire on more than –

Feckless Freddy who also starts at GS but spends his first ten years there binging on booze, birds and cars. When he’s 35, however, he meets his true love and settles down. They have The Money Talk and Lovely Lucinda gets Feckless Freddy to start paying into his NEST pension at 8% of salary.

The articles are wrong. Brian retires on 5,700 and Feckless is on 7,400, nearly 30% more! What went wrong? A spreadsheet showing how our three fellows do over 40 years can be seen here.

For Burnout Brian to get the same pension as Feckless, everybody has to achieve a real investment return of 6.8% in real terms, year on year throughout their investment careers. Now Warren Buffett can hit that. Over 40 years to 2006 he delivered a 22% year on year return. Over the same 40 years, US inflation has increased prices by 520% so you have to scale his performance down to a still very creditable 13% p.a. in real terms.

You aren’t going to do as well as Buffett. You have to be very optimistic indeed to anticipate an investment return of nearly 7% in real terms year on year for 40 years.

We all want to believe in magic, but the magic of compound interest is just not that strong in the real world, over a normal human lifetime. Where it comes into its own is for multigenerational wealth accumulation. If you’re an Ivy League endowment fund, sure, compound interest working over hundreds of years can work for you. If you have multiple lifetimes for your money to work over, particularly if you can hibernate for one of those, you’ve got it made. Vampires may have the edge here – long lived, long periods in the coffin keeping spending down, what’s not to like apart from the bad press and difficulty finding a dentist?

become a long-lived vampire to get compound interest really working for you

Compound interest is very dangerous to the economy in the hands of dead people with ambitions beyond a single human lifespan, it is so dangerous that laws like the Perpetuities Act have been enacted to prohibit testators projecting huge economic force centuries into the future.

If you’re Lucky Luke or Burnout Brian, then a large majority of your pension fund comes from the magic of compound interest. The downside of that is your fund just ain’t that big. Burnout Brian is on a quarter of the average wage, and he probably didn’t have enough time to pay off his mortgage before his burnout, so his costs include rent and are higher than Feckless Freddy, who owns his house outright.

Something else that this simplistic treatment doesn’t allow for is that Feckless Freddy may have been feckless but he may have got some career progression. As a result the 8% he is putting into NEST may be 8% of a higher salary. Look at my career progression. A lot happens after those first ten years. It would only take a thirty-percent bump up in Feckless’s starting point or a sudden heft like the 20-25 year mark of my career to have Feckless Freddy on twice as much pension as Burnout Brian. Say Feckless Freddy pays his mortgage off a little bit early. All of a sudden he doesn’t need to pay the mortgage. He can save that into a pension, tax free. He might even be able to get the money out without paying tax by using the 1/4 pension commencement lump sum tax free allowance.

I’ve got it in for boosters of the magic of compound interest, because I was Feckless Freddy. When I stopped working for the BBC in London I took the accumulated money from the three or four years’ worth of BBC final salary pension I had accrued as a taxed lump sum of £700 (worth about twice that now, according to the Bank of England’s inflation calculator). I did investigate at the time whether it could be transferred into my current employer’s final salary scheme, but for some reason it didn’t work out.  So my pension fund is about £2k less. Big deal. I started pension saving effectively in my very late 20s. In the last three years I’ve made up the difference and then some.

Look at Feckless Freddie and Burnout Brian. The reason Feckless’s pension pot is bigger even though he started ten years after Burnout is because Feckless stayed at work and continued saving for twice as long as Burnout. He’s put in 100% more than Burnout, and compound interest just can’t compensate for that with realistic rates of investment performance.

Therein lies the message. It isn’t fairy tales like the magic of compound interest that does the heavy lifting. It is steady saving of 8% of your gross salary for more than 20 years that does the grunt work, and then compound interest helps you out by up to 60% if and only if you can achieve a 5% return in real terms. If you’re into FTAS index tracking your returns over the last 5 or 10 years have been about 5%p.a. or about 3% post inflation so your compound interest is definitely lacking in magic compared to the 5% I assumed. Some of you have just had ten years of this, and the bad news is that there is the mother of all incoming financial shitstorms looming on the horizon…

In the case of a defined contribution pension scheme it becomes more and more attractive to hit pension savings as hard as you can late on in your career. You’re more likely to be paying 40% tax which you can save. You’re more likely to have paid off your mortgage, so able to save more of your income. You’re less exposed to government skullduggery in changing the taxation of your pension when you’re within five years of drawing them compared to if you are thirty-five years away. My pension isn’t DC, however there is a DC component in the additional voluntary contributions section of mine. So I hit that hard. You just can’t say no to a 40% saving going into a fund you can use tax-free in five years’ time; that’s an investment return on the tax saving alone of 8% p.a. and rising to 40% in the last year (less inflation, of course). That’s a very different proposition from saving 40% going into a fund you have to wait more than 10 years to get hold of, even if it does grow at 5% p.a.

The job of achieving financial independence isn’t easy. Saving small amounts early in your career and expecting the magic of compound interest to let you kick back after ten years just won’t work, and the reason it won’t work is that you must look at investment returns in real terms, which just aren’t big enough. Look at the investment return values used by Morningstar – a return of 12% is only 1% shy of the returns of the greatest investor that has ever lived. Del Boy and Rodney just ain’t going to manage it. If anything there’s been a marked long term decline in stock market total returns over the years. Returns are broadly correlated to GDP growth and where are we going to get more of that from in future?

Compound interest may perhaps add about 60-70% to typical pension returns over a working lifetime. Not to be sneezed at, but the biggest determinant of how well you live after stopping work is how much of your income you saved. Upping this ratio does you two favours. One is it by definition increases the amount you save. The other is it stops you inflating your lifestyle with all those consumer fads they try and sell you on the telly, and stops you buying too much house for your needs. Much of the key to financial independence is cost control. Spend less rather than earn more, particularly if you want to retire early.

I feel strongly about taming the meme of the magic of compound interest and the futility of saving in the second half of your working life because when it became apparent to me two and a bit years ago that I would probably not manage to carry on working to 60 I heard the compound interest message and figured there was nothing I could do to shorten my working life. I was Feckless Freddie, I was missing those vital early years that I could never get back again.

It wasn’t true, but at the time my world-view was distorted (okay, more distorted than it is now 🙂 ) and I did not have the energy to analyse this myself, until I came across this post by ERE which showed that there was a way to beat the tyrant of compound interest that is supposed to save everybody else’s bacon. And that way could work, even if applied at the eleventh hour.

Extreme saving is not an easy way. I find it hard to fill my ISA each year because I am saving more than that into my pension, and about the same amount into cash savings to carry me across a few years of finishing work so that I can defer drawing my pension. In three years I have saved twice my gross salary, spread across pre-tax pension savings as post-tax ISA and cash savings. That’s the equivalent of four or five years of my inflation-adjusted gross salary in the first decade of my working life, the Sensible Susan years. I don’t care how sensible Susan is, she’s just not going to save half her gross salary in her sensible start-young saving decade. Even if compound interest magically doubles her savings over the ensuing thirty years, she’s not saving 25% of her salary which would match in real terms what I’ve done in the last almost three years 🙂 .

Now you don’t save that much by skipping lattes and using quidco. You do that by going into across the board lockdown mode, you do it by investing for income, and you do it by having the brass nuts to throw more than half your salary into the stock market from April 2008 onwards. I was doomed anyway, but I still had enough intellectual capacity to understand the logic of this sort of thing.

In those three years I will have enough capital to make up half the value of my pension if I drew it early. Compound interest be damned. There are other ways, if you are desperate enough or want it enough. To achieve extraordinary goals you have to do extraordinary things.

I may not draw my pension early – I may choose to live from my cash savings and investment income, or convert more of my cash savings to investments to get more investment income. As the ad said, a man with savings can choose his way in life. I didn’t get that freedom of choice from compound interest. I got it from extreme saving and the peak of my earning power. At current rates of investment returns, Feckless Freddies can beat the legendary Sensible Susans/Burnout Brians. They just have to apply themselves to the task in hand with extreme prejudice. If he pays down his debts, Freddie can save a lot more than Brian’s 8%, and from a higher income base too. Don’t underestimate the capacity of an doomed and angry greybeard on the final approach at the height of his financial power, compared to the puny financial capacity of the young pup in his first decade of working life 🙂

Oh yes, and if you are the young pup looking to get out of paying into your pension, well, you have been warned. You have to get the career progression to be that greybeard before you can wield that power. This is not a foregone conclusion in a world where the power is shifting from labour to capital.


14 thoughts on “The Magic of Compound Interest is Vastly Overrated”

  1. It’s so heartening to know that there are more grey-haired Feckless Freddies out there like myself.I also think the ERE way is the best, always have thought that way. Although,I am trying to be more disciplined with myself than before, I still managed to pay off my mortgage despite the crash.Right now I save, invest and am trying to do some catching up in a pension fund. the future still looks bleak but not as bad as it could have been had I done nothing.


  2. Thanks for expanding your thoughts here, and for the links through to our radioactive compound interest piece on Monevator. 😉

    We’re not going to agree on this, not least because I don’t feel you’re comparing like with like. Why does the early saver give up saving later in life? Why would s/he make some modest extra savings — much less than the consumption hari-kari required by Feckless Freddie — to still come out ahead in pension terms?

    In short, why not belt first and braces later if required?

    Where I do agree is that saving and questioning consumption are a valuable habit to get into at any age. If nothing else, if you’re going to retire on less because you didn’t save all your life, it’s good to get mentally prepared for a frugal lifestyle earlier, and to realise your ‘worth’ isn’t dependent on your consumption.

    I also agree with Jacob and to an extent yourself that hard saving in your youth and *then* compound interest is the best setting for the compound interest machine. That’s been my path, and one I think more young people should consider while they’re bright and beautiful enough not to need all the trinkets.

    The S-curve post by Jacob is magnificent. He really has a unique way of looking at personal finance.

    Merry Christmas old chap! 😉


  3. An excellent post. Most magical-compound-interest illustrations ignore inflation, make wildly optimistic assumptions about investment returns and do not consider volatility in any meaningful way. Then there is the question of gilt yields and annuity rates…


  4. I certainly agree that CI on small sums of capital is never going to have much practical benefit, but of course it’s a useful benefit on top of a substantial saving habit.

    A working life of 25-30 years with a 15-20% saving habit is sufficient for retirement by 50 and is probably within the reach of at least half the population. Don’t think I managed that, but then I had some luck too. Merry Xmas.


  5. @all – Merry Christmas and a successful New Year to you, I’ve enjoyed the debate and learned a hell of a lot from you – thank you!

    @Monevator I don’t think that’s radioactive at all, and I wholeheartedly agree with your post to forestall any young readers extrapolating from my particular experience. Your aim is more general than mine. The area of disagreement is more specific. It is that toxic, and wrong, example of a Captain Sensible saving from 25 to 35 ending up with more pension savings than Cap’n Blithe. He doesn’t. It is wrong. Just to check, I’ve run the same simulation against my own career arc rescaled to real terms with RPI and assuming I were saving into NEST. In my case, you would need to exceed a real return of 8% for Sensible to end up with more than Blithe, even ignoring any Johnny-come-lately attempts to catch up. This is presumably because of the career progression. Somewhat embarrasingly, I actually do better from compound interest that the flatline example, even given my shortened career, again presumably from the mid-career heave.

    The reason I went on at length is a) I don’t think people should base things on models that don’t work in real-world returns and b) that widespread but wrong example nearly robbed me of hope at a turning point. If this post counters this fallacy in a Google search for some Feckless Freddie who reads the writing on the wall then it will have served. Of course I agree with the rest of the general principles that one should take a more graduated apprach to retirement savings. I do think 40 years to retirement is a little bit early for that given the other calls on a young person’s wealth as long as they are saving the same amount to those other aims but I do agree that they ought to have made a start at 30. I owe you both backup to my assertion and perhaps I may expand on why that example nearly cause me to run up the white flag at a turning point…

    @g we aren’t as lost as people make out, eh 😉

    @SG That’s an interesting clarification of how much is needed, I will run that simulation with that scale factor too. It might explain why I might get away with this, as FS pension schemes do seem to accumulate at a higher rate than the 8% cited by NEST.


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