Saving for retirement is arguably the most prominent piece of financial advice floating around. Yet, instead of putting spare cash aside in an interest-bearing account, it might be wiser to start buying cheap shares.
People can’t work forever. And once the money stops rolling in from a job, having a chunky pension pot can provide a far more comfortable lifestyle.
But while using a tax-efficient savings account is a viable near-risk-free approach, the stock market may offer considerably better returns, even with the latest interest rate hikes. Let’s take a closer look.
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Creating income using stocks
Creating an income stream from retirement savings is fairly straightforward. Today, top savings accounts are offering rates of around 5%, or higher. That means for every £100,000 saved, £5,000 is coming into my pocket each year. It’s not a groundbreaking sum, but when paired with a State Pension, it can be a massive helping hand.
Stocks offer a similar income-generating solution through dividends. But looking at the FTSE 100, yields have historically hovered around 4%. Obviously, there are plenty of businesses offering slightly more without venturing into the realm of unsustainability. But given the significantly higher risk levels of the stock market versus a savings account, why would anyone choose to invest?
The answer is simple – growth. Unlike the interest rates on a savings account, which is ultimately determined by monetary policy, dividends are driven by earnings. And a company that can consistently increase its sales and profits can turn a modest 4% yield today into a far larger one in the long run.
For example, billionaire investor Warren Buffett invested in Coca-Cola in the 1980s. But, the soft drinks business has increased its shareholder payouts every year since.
As a result, Buffett is now earning more than 50% returns on his original investment every year from dividends alone. And that’s something no savings account can come close to.
Building a pension pot
Dividends are just one side of the coin in the stock market. Capital gains are the other. And assuming the FTSE 100 continues its historical trends, investors can expect to earn an average of 8% a year. For those capitalising on individual cheap shares, this potential gain could be elevated even further.
Let’s assume a portfolio achieves a 10% annualised return. Investing £200 a month at this rate across the average length of a career – around 40 years – would build a nest egg worth £1.26m! By comparison, a 5% savings account would only muster £305k over the same period.
That could be the difference between a comfortable and luxurious retirement lifestyle. But as tempting as the stock market is, risk cannot be ignored. Dividends can be cut, and stocks don’t always go up. In fact, even the best businesses in the world can suffer short-term plunges in their valuations.
2022 served as a perfect example of this. And depending on the timing of such events, a nest egg may end up being far smaller than expected.
Nevertheless, it’s an endeavour worth pursuing in my mind, given the potential rewards.
