The two big benefits of starting a pension early

By May 20, 2021Pensions
Young woman at table with laptop and documents reviewing her finances

If you have people in your life who don’t feel it’s worth putting money into a pension, you might show this article to them to help change their minds. It could prove an invaluable piece of advice in years to come.


Back in February, research by Royal London revealed that within the millennial age range (18-34-year-olds) two in five respondents had stopped or reduced their pension contributions following the coronavirus pandemic. A similar survey published by also reported 24 per cent of under-35s said they had no pension savings at all. That’s a worrying trend, as it means that many young people are avoiding paying into pensions precisely at the time when making contributions can make all the difference to their eventual retirement pot.


Why are young people out of the pensions loop?

It had been expected that the UK government’s workplace auto-enrolment scheme would make sure that the majority of young people would start paying into a pension of sorts. But after a year when many young people’s jobs and lives have faced upheaval because of the coronavirus pandemic, it seems that a large proportion are outside of this safety net. Perhaps the rise in ‘gig economy’ jobs, as well as self-employment, is behind the lack of workplace pension take-up among the millennial age range.

Of course, pensions are always a tough sell with 18-34 year-olds anyway. Encouraging people to start up their own self-invested personal pension may seem a low priority when money is tight and they are still paying off student debts, have bills to pay, and want to spend any surplus money enjoying themselves.

But there’s no getting around the fact that the very best time to start a pension is when you are young. And there are two main reasons why: compound interest and tax reliefs.


Compound interest

There’s a quote that’s often attributed to Albert Einstein that “Compound interest is the eighth wonder of the world”. Now, Einstein may not have actually said this, but whoever did say it might have been onto something.

Compound interest simply means that once you start paying into your pension, you don’t just earn interest on your savings, but the interest starts earning interest too. Think about compound interest like a snowball. The longer the snowball rolls downhill, the bigger it gets. This means that even small pension contributions could have a meaningful impact over time.


The effect of compound interest on your pension pot

Consider two pension savers, Susan and Phil. Susan started putting money into her pension when she was just 20, investing £50 a month. Phil waited until he was 40, but began investing £100 a month.

Assuming an average annual interest rate of 4% (and assuming both keep paying in the same amount every year), by the time Phil reaches 60, his pension pot will have grown to just over £36,500. But by the time Susan reaches the same age, her pension will be worth almost £60,000. Even though both Susan and Phil will have invested the same amount over time, Susan will end up with almost twice as much, thanks to the power of compound interest. Eighth wonder indeed!


Taking advantage of tax relief

While compound growth is one of the biggest benefits of starting a pension as early as possible, another valuable incentive is tax relief on pension contributions. When you make a payment into a pension, the government makes an additional contribution that effectively repays your tax at the rate you usually pay. In other words, the government will actually pay money into your pension – that’s how important it is to have an income during retirement!


The effect of pension tax relief over time

Returning to our previous example – with Susan benefiting from a much larger pension pot than Phil – the advantages are even greater when you factor in tax relief on pension payments.

Each time Susan pays £50 into her pension, her pension pot increases by £62.50. As a basic rate taxpayer, Susan pays tax at 20%, and her pension contributions are paid into her pension as if they have never been taxed. So, after taking into account the available tax relief on Susan’s pension contributions, she is looked at a retirement pot available at age 60 of closer to £72,800.

And what about Phil? Well, for the sake of this example, let’s assume Phil pays income tax at the higher rate of 40%. This means that each of his £100 pension payments are adjusted to become £166. However, despite this, Phil’s pension pot will still end up behind Susan’s, at around £60,600.

What this example demonstrates is that a person with a relatively modest income, who only pays a small amount into their pension, and receiving half as much tax relief, can still end up with a significant retirement pot, just by starting their pension sooner. So, if you have family members who don’t think they earn enough to pay into a pension at their age, this might persuade them otherwise. You might also want to remind them that even if they can only afford small pension payments now, they can always increase the size of their contributions later, as their income increases.

The twin drivers of pension growth – compound interest and tax relief – are really too good for anyone to ignore, and they certainly make a convincing case for putting any doubts about pensions aside. According to the old Chinese proverb: “The best time to plant a tree was 20 years’ ago. The second-best time is now”. The same applies to pensions.


If you are interested in discussing pension arrangements with one of our experienced financial planners at FAS, please get in touch here.


This content is for information purposes only. It does not constitute investment advice or financial advice.