When you start retirement saving, one of the hardest things to deal with is that it seems so hopeless.
You can’t imagine ever being able to save enough to build a decent retirement pot — perhaps £500,000.
The good news is that thanks to some maths magic, it gets much easier after a while. When you’ve been saving for a few years, you start to benefit from something called compound interest.
What is compound interest? It means earning interest on previous years’ interest. This accelerates the growth of your savings. Compounding is like a snowball. As it rolls down the hill, it gets bigger and bigger. After a while, it’s unstoppable.
Let me show you
The best way to illustrate this is with a couple of examples. Let’s imagine you put £100 into a savings account paying 5% interest each year. Each year, this 5% interest is reinvested into the same account, so that the next year you’ll also earn 5% on the previous year’s interest.
Here’s how much your money will have grown after different time periods.
|
Year |
Value |
Five-year growth |
|
0 |
£100 |
n/a |
|
5 |
£127.6 |
+27.6% |
|
10 |
£162.9 |
+35.3% |
|
15 |
£207.9 |
+45% |
During the first five years, the value of your money will rise by just 27.6%. However, during the five-year period between years 10 and 15, your money will increase by 45% — nearly double the earlier increase. That’s the magic of compounding.
How can I make £500,000?
Sadly, savings accounts that pay 5% are non-existent these days. The highest easy access cash ISA rate I could find at the time of writing was 1.44%.
For a long-term investment where you want to make monthly payments, although property can work well, it’s hard to get started without a lump sum. I believe the best choice is the UK stock market.
Over the last 100 years or so, it has delivered an average annual return of about 8%.
If you combine these returns with a monthly deposit of £200, then I think building a retirement pot of £500,000 is completely realistic. I’ve crunched the numbers so you can see how this might work, based on the 8% stock market return I mentioned above.
|
Monthly saving |
Approx. time to reach £500k |
|
£200 |
36 years |
|
£300 |
31 years |
|
£400 |
28 years |
|
£500 |
25 years |
Of course, these are only approximate figures. Over short periods, the stock market goes up and down and the income you receive from the market may vary. But over the long term, the stock market has historically been a good way to build personal wealth.
Invest like Warren Buffett would
Unless you’re an experienced stock market investor or have a lot of time on your hands, I wouldn’t suggest buying individual stocks. Instead, I’d follow Warren Buffett’s advice.
Although the US billionaire invests in individual companies himself, his advice to his family and most other people is to buy a cheap index tracker fund. I’d choose a FTSE 100 tracker in the UK.
These funds follow the wider stock market and pay dividend income twice a year (choose accumulation units so that this is automatically reinvested).
To keep your hard-earned retirement savings safe from the taxman, I’d put them in a Stocks and Shares ISA. You can pay up to £20,000 per year into one of these accounts, and unless the rules change, you’ll never have to pay tax on any income or capital gains generated inside the account.
It really is that simple. I’d get started today.
