It’s January. The nights are long, and it is cold, and rainy. It’s about this time of year that they always run the articles abut Blue Monday when it’s the most miserable time of the year, because we are done with the Christmas debauchery and it still doesn’t feel light even though the Sun is rising earlier. They are still wittering about the economically inactive. The BBC have at least identified there’s not much chance of getting you FI/RE lot to do your patriotic duty for the economy.
Almost nobody who has retired early says they want to return to work.
A new year, new start
I am old enough to have determined new years resolutions don’t work. I don’t do gyms anyway, but the best way to avoid that sort of resolution is not to pig out to excess extendedly. It’s OK to eat and drink to excess a couple of times in the Christmas period, but debauchery and gluttony are to be avoided in excess.
One thing I am experimenting with is to reduce screens/online. Interesting that Weenie is taking up jigsawing to go in this direction, is it a zeitgeist thing or great minds…
I have already taken step through the end of last year to reduce news consumption. I still remain informed, it’s the time/attention thief I am trying to reduce, rather than to do the full Walden Pond thing. One way is to to act more like it were 1998 on dial-up. As long ago as work I got a win on this with email by not running it all the time, once in the morning and once in the mid-afternoon. I have forgotten what office-worker’s guru put me onto that but it worked. For a wider win I aim to concentrate interwebs in bursts, like it were before the Millennium. GenZ has taken this battle to the enemy with customary panache, at the cost of never clocking off. I wonder if that Zuckerberg isn’t barking up the wrong tree trying to create the metaverse. It’s already here, just unevenly distributed. Poor old Zuck he’s pushing forty, and his younger self called the problem out
Young people are just smarter
I get to listen to a lot more music. Which is more reflective than using t’internet, although when I stream it is from a NAS rather than the likes of Spotify or Apple. I did consider using Tidal but I still can’t bring myself to do subscriptions. It is possible to buy downloads from Qobuz but it’s usually cheaper to get the CD s/h. I listen to music through the electric, instead of on their phones.
Looking around me, I see quite a few semi-old gits pumping money into their pensions, and lots of it. I’m one of them. We’ve all got it horribly wrong, you should start saving when you’re young.
Optimum pension contribution rate from the paper referenced by the FT. There is some similarity with my AVC contribution rate.
I was probably wrong – compound interest is all very well. Why it doesn’t work as well as people like to make out is that in your twenties you can’t put any decent amount of money into a pension, because of where you are in your financial lifecycle. You’re not earning much, so the basics of life are a higher proportion of your outgoings. And you’re starting out in life, so you aren’t as financially savvy as you may get, plus you have to buy lots of stuff to establish life as an independent adult. Merryn gets to the heart of the matter
We all think that we should start saving into our pensions from the moment our first paycheque hits. But it turns out that if we were “rational life-cycle financial planners”, we would wait until we are into our mid-thirties to save.
Everything we do financially should be to maximise our standard of living over our life cycles. In our early career years, when our earnings are low, we compromise our living standards if we save.
So we should consume our initial incomes and then step up savings as we earn more: with the percentage rising from zero before age 35, to 30-35% as we head towards 60.
Now I haven’t followed that exactly, but there has been a huge increase as I’ve got older. And as Merryn intimated, it gets so much easier to save as you get older, though with the caveat that having children and aspiring to help them with university costs can put the kibosh on that. Previous generations became financially independent of their parents as they came of age, making saving easier for the parents once they got into their 50s.
The takeaway isn’t that you should blow it all in your 20s – you should still be saving or building capital. Either in house equity if that is your bag, and you expect house prices to continue rising (why?) or in financial instruments to give you a passive income, which is equivalent to home ownership reducing your housing costs.
It’s hard to know the benefit of not having housing costs until you experience it. In my twenties I perpetrated the biggest misallocation of financial resources in my whole life by buying a house at the peak of the market, signing a mortgage document that was to be discharged in February 2014.
That screw-up was redeemed by paying down that mortgage about six years early. Not having to pay the mortgage means I can save much faster, for the simple reason that I need access to far less of my salary. Using salary sacrifice I can stop the Government stealing a lot of my pay, allowing me to save two year’s gross salary in three years by booting much of my salary into pension AVCs.
I don’t have to live on thin air 🙂 I live on an annual expenditure of less than the national minimum wage, but I have a standard of living that is much higher than you’d expect from that because I am using the accumulated capital from earlier years.
That is why compound interest doesn’t benefit me much in investment, I haven’t got the 40 years it takes to do anything useful at a 5% compounding rate – but that doesn’t greatly matter. I focused my investment as a young man in paying down my mortgage debt. That is still working for me – by dramatically lowering my costs so I can save and invest now.
Investing is a dangerous game, particularly for the young-ish and optimistic – I was slaughtered in the dot-com bust, largely from being too hot-headed and not knowing some of the ropes. You can get round some of that as a young investor by using passive investing, provided you start at a good time when equity market valuations are cheap. If you passively invested in the dot-com boom you’d still have been slaughtered in the last ten years, just not as quickly and perhaps not as comprehensively as I was. (edit – no you wouldn’t – see this comment for why)
Am I a better investor now? It’s impossible to know without looking 10 years ahead. I have better guidance, I have the learning from last time, and I am richer, so I won’t become a forced seller because I have more than half my non-pension savings as cash. I diversify by sector and to some extent by geography, though not financial asset-class, I’m either an equities guy or into non-financial assets. Well, apart from cash, I guess.
It surprises me that there’s so little said about life cycle financial planning. If you’re wealthy enough to be doing financial planning, you will probably experience a similar sort of life cycle. Yes, timing will be different for people who have children, but the arc of the life-cycle will still follow similar stages – you’ll probably be skint and capital-poor when young, you’ll be better off though probably with more dependents when middle-aged, then more capital rich but with a lower income when older. Saving 5% of my salary was a much bigger ask in my 20s than saving 70% of it in my 50s.
I was lucky in a lot of aspects, despite being hopelessly incompetent with the housing market. Rolling with my financial life cycle was probably one of those pieces of luck. I didn’t sit down to do it at 30, though some of it was instinctive in following the financial life-cycle of my parents, who discharged their mortgage when my Dad was in his late 40s, earlier than me.
Someone in their early 20s who takes Merryn Somerset Webb’s article and uses the information with self-knowledge, determination and persistence could do well by maximising their life-cycle standard of living. Of course, the need for self-knowledge, determination and persistence at 20 may be the rub. I struggled with the self knowledge, else I would have listened up and not bought a house at a market peak because I wanted out of the endless having to move because of other flatsharers’ life decisions.
Anyway, in one sense I was wrong about compound interest being overrated. It’s great. It’s just not useful to most of us who start out their adult lives skint and with massive claims on our income for the necessities of life. Obviously if you start work at Morgan Stanley in your twenties, fill your boots and all the great stuff about compound interest will come good for you.
References
For the more analytical, the Pensions Institute papers referenced by the FT are
Age-Dependent Investing: Optimal Funding and Investment Strategies in Defined Contribution Pension Plans when Members are Rational Life Cycle Financial Planners by David Blake, Douglas Wright and Yumeng Zhang (Sept 2011)
and
Target-Driven Investing: Optimal Investment Strategies in Defined Contribution Pension Plans under Loss Aversion by David Blake, Douglas Wright and Yumeng Zhang (Sept 2011)
The standard advice for anyone in connection with pensions is start early, young man, start early. Do it, and do it now – your early savings are what makes all the difference.
I didn’t. I effectively started at 28, and even worse because I want to retire early I effectively started later in my working life. For a normal worker in my industry retiring at 60 I would have been saving for 32 years whereas I’ll be lucky to reach 25 years. I’m therefore like a normal worker starting at 35. Because my company pension is a final-salary one, the difference is less than it would be with a DC scheme. However, I’ve had to make changes in the last three years to try and make up for the difference.
Because I own my house outright this has been easier for me, and it make me wonder if the standard advice is simplistic, and people should take a systems approach to their lifetime finances. In a later post, I will try and work out what proportion of income I did spend on the various key aspects of life (housing, hedonism, tax and pensions). The information isn’t precise for some of the early years, and yet I believe it shows that as long as you do save for some key asset classes in your 20s, it doesn’t have to be a pension in those earlier years.
I’ve analysed my working life, and mortgage, rescaling values to eliminate the scourge of inflation which makes it so hard to compare values over a thirty-year working life. Here, I have looked at various pension saving scenarios and how they would work out, as if I were saving into a defined contribution pension at 15%, about twice the rate of NEST’s 8%. Defined Benefit (final salary) pensions are better than NEST largely because more money goes into them, usually from the employer so it is not always visible to employees. However, a pension is deferred pay, so two employers both offering the same salary but one offering more contribution to a pension are actually offering different salaries.
First off, an extreme wealth warning. If you are in your 20s and looking for an excuse to live it up at the expense of saving this is not your ticket to ride. You have far more unknowns ahead of you that I have in describing this story, because I am in my early 50s and my career trajectory is known. If you’re young and you use this to justify not saving your 8% of income into a pension then you need to save 8% of your income into some other asset, and assets do not include most of the things you might want to buy 😉
I got into deserved hot water over here for the assertion that you can make up for a lack of saving in your 20s, and that compound interest will not necessarily ride to the rescue. Not because I didn’t get away with it, but because
@ermine — Thanks for the follow-up. I’m going to argue strongly against what you’re saying, for the sake especially of young readers reading, as I think it’s dangerously misleading.
[…] I don’t want Monevator to help put people on the exactly the opposite path that I set out to postulate, and that we post on every day – i.e. at a minimum, realistically aiming to achieve financial security within their lifetime, or better yet some financial freedom.
Consider yourself warned young person, Monevator is right in that you can’t know until you are 50 that you won’t take some important hits I didn’t. I am looking back over my working life and I know what happened. Young reader, you are looking forward over an unknown career arc. You may have less luck that me. In particular, if you are a woman in your 20s do not follow my path. I will explain why later, but you are exposed to more serious risks statistically that men at the same age. It’s not feminist, it’s not fair, but it seems to be what happens, and you should protect yourself against the world as it is, not as it should be.
Having said all that, I consider this pretty clear proof that the magic of compound interest is not all that it is cracked up to be, and that is is perfectly possible for someone who has a career path similar to mine to catch up for the lack of early pension savings in ther 20s. Observe that I did not accumulate any debts in my 20s, and my savings went towards putting down part of a 20% deposit on a house I stupidly bought at the height of the Lawson boom. For all the good those savings did me I could have drunk it all in the Television Centre bar and had twice yearly holidays in the sun, but I stuck with just reasonably excessive drinking and one holiday most years.
The community that can take inspiration from this analysis is the one of the greybeards who didn’t follow the recommended route, and delayed saving till their thirties or even forties. As long as they didn’t screw up with debt, and as long as they paid their mortgage down at the recommended rate, they can recover without working till they drop, through the application of ERE’s methods, but perhaps calling it Earlyish Retirement Extreme
Setting the scene – how I simulated different saving approaches
To try and make sense of the last three decades, I have taken my salary and normalised it to 1 for my first proper job with the BBC in 1984. I am British, and unlike our American friends I just don’t like talking about how much I earn. Regular readers have probably roughed it out by now, but you ought to have to work for it.
I’ve then rebased everything by scaling for inflation using the RPI index, setting that first BBC job to a nominal value of 10000 pounds. In the RPI adjusted world I have created, that 10000 pounds holds its value across the three succeeding decades, because I deflate prices and my salary by RPI inflation.
an ermine’s inflation-adjusted income and mortgage stupidity
You can see that over the years I improved my income in real terms by over two times. The dip in 1987 was when I took an MSc with a Manpower Services Commission grant. You can also see that the ermine is taking a hit from the stinginess of my employer and the rampant inflation of late towards the end. The actual high-water-mark of my real income was in 2008.
I’ve also represented my mortgage on that. Look at that awesome income multiple of what, 5 times? Millennials and the Priced Out generation take note, I had to stump up a deposit of about 10% to bring that multiple down to within spec so my debt was lower. I then had to borrow another 10% interest-free on a credit card advance to avoid taking the shaft from high loan to value insurance, which I paid down in the first year. Whenever it looks like a good idea to pay more than 4*salary for a starter house, STOP. You are either earning too little or paying too much, just like me 🙂 What isn’t shown here was I had an endowment mortgage which I only managed to conclude a mis-selling case on in 2004. Friends Provident sold a single ermine with no dependents a life insurance product, FFS. Fundamentally I shouldn’t have been so stupid, but at least I did get the situation restored to what a repayment mortage would have been (the endowment had fallen behind by 1/3). That payment from the endowment is why it looks like I robbed a bank in 2003/4…
Although I was a feckless young ermine, taking my BBC final salary pension as a cash lump sum on moving to my current company, I am lucky enough to have been in a final salary pension scheme since then for the rest of my working life. Taking a leaf from SG, I have simulated that pension with a steady pension saving rate of 15% from my rebased and inflation-free income, compounding at 5% which seems a reasonable estimate for the long run stock market total investment return after inflation. Mind you, someone who has been saving using an index tracker over the last decade may take a dim view of that 5% assertion! I’ve then modelled how various different variants of me would have done with different pension savings strategies.
Meet the Cast of Characters
Steady Eddie
First we have Steady Eddie. He starts work, saves his 15% gross into a pension scheme from 1983 until he retires at the end of 2010, 27 years later. He is the benchmark for how you should save into a pension. In all these graphs, the magenta bars are the parts contributed by the magic of compound interest. Note that most of this is Eddie’s own saving, though I do agree it would be churlish to deny the value of compound interest, as it makes up 48% of his pension capital.
Steady Eddie. Take it slow, Eddie, this is how pension saving should be done
He has experienced the same career progression in real terms as I did, so he earns just over twice as much as a greybeard as when he got his first real job. I normalised his wages to £10000 in 1984. I don’t count my very first job as that was a poorly paid technician post; I started looking for work in 1982, into the teeth of Margaret Thatcher’s first serious recession, so I took the first vaguely relevant job I could get. Eddie is sitting pretty with a pension of 6554 pounds in my normalised universe with a pension capital of £131000. That’s slightly under 40% of his average salary and 28% of his final salary. I am lucky; if I left and drew my pension now I would get a higher percentage of my final salary, and I am duly grateful for my good fortune in that I have had a stable job that has been interesting and rewarding for the vast majority of my time there, regardless of things that may have gone wrong in the recent past.
Sensible Susan
The only lady in the bunch, Sensible Susan follows the same path as Steady Eddie for 11 years. Ball-breaking feminists are going to hate this, but she then quits work to have children.
What can I say? I’ve observed it happen that way often enough, and even if Susan returns to the workplace the missing years are critical to one’s career deveopment. Though my pay didn’t go anywhere in real terms in my 30s the projects I worked on built the platform on which I got the next decade’s rises. However, since she was sensible, Susan has built the classic early starter ‘magic of compound interest’ example of saving for ten years and stopping. Except I’ve had her save for eleven years, because I took time out to to an MSc in 1987 and it seems a bit tough on the Sensible Susan version of me to KO 10% of her earnings as well as well as have her stop work early. Articles like this, this and this lead us to believe that the magic of compound interest will save her pension, but a casual inspection of her savings graphs relative to some of the later more feckless versions of me will show that just isn’t true. I have kept the vertical axes the same scale.
Sensible Susan – the magic of compound interest (magenta bars) works for her but it doesn’t make up for the serious lack of contributions
Sensible Susan is on less than half of Steady Eddie. Compound interest makes up more than half her pension capital (66% of a total of £53000). She’s going to feel the pinch with less than half the pension of Eddie. On the other hand, she’s contributed less than a third of Eddie’s contributions. That she is closer to half than a third of his pension speaks something for the magic of compound interest but no way as much as you’re led to believe.
Feckless Freddie
He’s a lazy B’stard, our Freddie. He spends far too much time in the BBC Television Centre bar eyeing up the beautiful people of the luvvie set, who are far prettier, and, er, of the right sex, than the hairy-arsed engineers in the bowels of TVC where he works. As a result, he doesn’t realise till too late that London prices appear to be getting away from him. One day he ends up in the Broadcasting House bar (a classier lot in those days, the Radio types than Freddie’s Television Centre chums) and listens to yet another gorgeous sylph-like Rebecca and her pretty-boy BF talking about how much the price of their house has gone up and “oh gawd, Tarquin, ahhhrn’t we rich, dahlink”. On the radio Freddie hears Elvis Presley singing “We can’t go on like this”.
and thinks to himself that yes, London, we can’t go on living like this, I am caught in a trap. As Freddie pulls his head from yet another pint of E.S.B. he looks up and gets his coat. Freddie figures he needs to go up the value chain a bit from being a studio engineer, and get away from the city that won’t let him live in it without paying exorbitant rent. After a Tube journey he gets on his bike to cycle up the Western Avenue from TVC to Hanger Lane, and thinks about a research job with more pay and a chance to buy a house. But first he needs to fix his ropey Batchelor’s degree. When he gets home he notes the beginnings of a gleaming white pelt starting to show.
Yup, Feckless Freddie was me. I did the MSc, returned to London for a year then moved up to Suffolk. House prices were still sky rocketing, and I had to get on the ladder before it became out of reach. Oh dear…
I did investigate whether my BBC pension could be transferred to my current employer, but it didn’t work out. If I had those three/four years they’d be useful but I’ve been here long enough it isn’t a huge amount. As a deferred pension it would be diddly squat, as it is referred to my final salary on leaving the BBC, so even if it didn’t lose over the years to inflation it would be referred to as final salary less than half of the one I retire on. So I used the £700 surrender value to a good purpose towards the deposit on the house. Oops…
So how does my alter ego Feckless Freddie get on?
Feckless Freddie and his Frantic Antics at the end
The three yellow bars are the savings I have managed over the last two and a bit years, effectively twice my gross annual salary. If we ignore these, we still see that Feckless Freddie has an accumulated pension capital of £78000, less than Steady Eddie but still a lot more than Sensible Susan. Why is this? It is because twenty years of compound interest doesn’t make up for Susan’s shortage of contributions, and this is made a lot worse by her lack of the boost provided by career progression.
It is the weakness of compound interest at realistic rates of real return, combined with the fact early pension contributors are contributing from a low earnings base that means all those stories about early starters staying ahead are just wrong. Feckless is obviously feckless, because he is about half short of Steady Eddie. However, he’s paid off his mortgage by the end, so he can now hit the tax-advantaged pension savings hard. His risk of the government shafting his plans is reduced as he is within a few years of drawing his funds, and the tax-free-pension-commencement lump sum could be just the ticket to make up for his fecklessness earlier. Feckless Freddie ends up with £129k, compared with Steady Eddie’s £131k. After three years of austerity, Freddie can sign up for his pipe, slippers and cruise brochures too.
The fact that Freddie ends up with the same as Eddie isn’t totally coincidental. I targeted making up for the lack of pension contributiuons due to my missing years as well as compensating for retiring early. I can’t compensate for both unless I work another two or three years, but I can eliminate one. The bar was set by what my own pension would be if I stayed to 60. My assumed real rate of return was 5%, and though I can realise that as dividends I don’t believe I will get a total return of that much even though I have bought mostly since the crash, and a lot at the early 2008 low. I think my share capital value will fall behind inflation in the years to come, but this will hopefully happen slowly so if won’t kill me off in the period between leaving work and actually drawing my pension. If my share capital and dividend income starts to get nuked, well, that’s why I have about the same amount as my shares ISA in cash savings, because there is the mother of all economic shitstorms coming our way. I won’t be a forced seller in that intervening period unless the value of that cash is destroyed because this sort of thing happens.
Looking at Sensible Susan’s holdings, note that what early saving and compound interest have bought her is insurance. She is unlikely to be totally unable to work again, and if she returns to the workforce then some of the same techniques used by Freddie are open to her. She is likely to reach a lower maximum salary in real terms than if she hadn’t taken time out of the workplace because other workers will have been honing their skills and schmoozing their way up the greasy pole in the gap, but there’s nothing stopping her making up some of the difference. Had he not done something drastic, Feckless Freddie would be closer to her pension than to Steady Eddie’s.
Finally, let’s meet
Stupid Steve
Steve couldn’t see the point of all this saving for retirement malarkey, life was for the living here and now. He’s been a bit stupid, really, our Steve, and only started saving for retirement for the last ten years of his working life. He’s almost like Sensible Susan in the number of contributions, but what makes him stupid and her sensible is he did it the wrong way round. Everybody tells you you have to save early on, right? So what happens to Steve, he’s going to get slaughtered, right?
Stupid Steve loses out, but not as much as people would think, since his contributions are twice as high as Susan’s
He’s had the same career progression as I did, so his pension contributions are made at the peak of his earning power. He’s on a pension capital of 43,000 compared to Susan’s 53,000. But he’s still got one ace to play that she doesn’t necessarily have. He’s still working, so if he manages to sock away twice his gross salary towards the end, getting himself up to 94,000.
Now there are some things about Stupid Steve that make you think perhaps he may not be the most financially savvy cookie. But there may be mitigating factors. Say Steve is self employed, and he’s been building up his business all his life. When you or I leave work, we have nothing to show for it expect a few beers down the pub, a gold watch and of course the pension. When Steve leaves work and retires, maybe he has a viable business he can either get someone to run and it pays a dividend, or he can sell the company as a going concern and recover the capital he built up over his working life. Suddenly Stupid Steve isn’t so Stupid at all, perhaps he is Smart Steve. He’s only doing the pension saving at the end because it’s rude to say no to a 40% tax break with five years or less to run.
for the much vaunted example of Sensible Susan ending up with more pension capital than Feckless Freddie, even if he starts 10 years later. They’d have to achieve an investment return of > 8.5% in real terms for that to be true, and it just ain’t going to happen.
The main thing you buy by saving into a pension early is insurance – against long spells of job loss, unpaid sabbaticals or incapacity.
Earlyish Retirement Extreme
The message to greybeards who have spent too little time saving in their youth – there is hope! You can do it. Austerity is a lot less painful for a 50-year old with their house owned mortgage-free than it would be for a 25-year old. Most of the things that are wrong in my life are to do with the fact I am working, the environment is enervating and it consumes a lot of my time. Very few of the things wrong in my life can I solve by spending more money!
The Archdruid identified the key issue in this post.
What most Americans do not know, and have no interest in learning, is that it’s possible to be poor in relative comfort.
I found the transition, from a normal average consuming lifestyle to one of consuming less, very hard. I was far more motivated to go through it because I was under the impression I would become unable to work or ejected from work in months. I wouldn’t have been able to complete the transition otherwise, but after six months of consumerism detox I was off it.
Above all else, if you’re doing Late Retirement Extreme saving as opposed to Early Retirement Extreme saving, you are probably saving at the peak of your earning power. To save in real terms what I saved in the last nearly three years would have taken me nearly seven years of saving at the BBC – I didn’t work there that long! Plus my outgoings were a higher proportion of my pay than they are now; what would I have done about paying the rent? Not only that, the money I saved would be locked away for three decades for governments to try and get their sweaty mitts on it, and I would have saved less tax.
As for seven years staying in my sleazy bedsit as opposed to three years reduced outgoings at home with the lovely company of DW, well, I dunno. Getting on isn’t all bad 🙂
the young person’s dilemma
Even for young people, and subject to this dire warning I’m just not so sure that locking your savings in a pension for 40 years (by the time you are 30 the retirement age is probably going to be 70+) is the best thing to do with any cash you may be able to save between 20 and 30. There’s lots of contrary opinion, like this and this to the effect that I am wrong here, so you have to make this call yourself. The primary risks that mitigate against later saving are if you expect to take significant time out of the workplace to pursue lifestyle choices or you expect career progression to be lower than mine. Taking time out tends to lower career progression, switching jobs between and within organisations more than me tends to increase it.
Look at those charts, and they are for a relatively short working life of thirty years, compared to 40 or 50 years that are implied by State retirement ages of nearly 70. As long as you start by the time you are 30, giving you 40 years to save before retirement, I’d say there may be other more pressing calls on your saveable cash. After all, though I was a dipstick for using my BBC pension funds towards a house, the financial strategy was right – put this into a capital asset. You recognise an asset because it either saves you more money in its lifetime than it costs you, or it pays you an income.
A house is a capital asset if it saves you rent, and the many reasons for not buying a house don’t outweigh the many reasons for buying a house. Machinery, services and supplies for a business are an asset if the business can turn a better profit than the cost of those assets properly depreciated would return on the stock market on in a bank. Your van is an asset if it lets you get more work than it costs, your Ferrari, designer suits and your Sky subs are not assets.
So as long as you understand assets, and as long as you save into assets or RPI index-linked cash the amount you would save into a pension (at least the equivalent of 8% pre-tax), I would say a young person might do well to take a strategic view that saving to a house or saving to buy assets for a business or saving cash is more relevant to their financial lifestream. Pensions advice is so one-dimensional. Do it. Do it now. How about no, let’s work out that this makes sense?
Assets can help you save in a pension later on. My house contributes £9800 p.a. to my pension saving – it would cost me £7k to rent it but I don’t pay myself rent or a mortgage and I’d have to pay 41% tax and NI on that, which I save going into a pension. That’s not a bad ROI, it’s actually over 10% p.a. on the RPI adjusted price I paid for it.
There’s a time and a place for pension savings. As long as you heed the dire warning and understand it, I’m not so sure between your 20s and 30s are that time. Just save that 8% of income somewhere accessible and tax-sheltered if in financial assets. Yes, you’ll lose the tax break now, but heck, you’ll probably pay basic rate tax on it on the way out so don’t sweat it. Who knows what tax will be in 40 years’ time! It is possible to make up for lost time. The amount I have in pension AVCs alone is enough, at a real return of 5%, to compensate for the six years of contributions I am short.
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.
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