I read with interest the other day that according to Albert Einstein, the 8th wonder of the world isn’t any natural or man-made structure, but is in fact, compound interest. Einstein famously said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” And I happen to like this idea, even if I may bore my friends talking about it!
My general interest in the topic extends from a vested interest in pensions, ISAs and other saving mechanisms, but more importantly, now I have a son to consider it bears thinking about in terms of helping prepare for his future.
You see, if you do the sums, as strange as it sounds every parent should consider starting a pension for their children as soon as they’re born. And because of the impact of compound interest, it shouldn’t really cost that much to provide a comfortable future cushion for your children. And unlike a Junior ISA which becomes a pot of money they have access to at age 18, the pension remains out of reach until they’re 55 – and hopefully, better equipped to understand long term financial planning.
For example, if you read the press an assumed growth rate for a typical pension fund over an extended time frame is generally set at around 7%. If I choose to contribute just £25 per month for my child’s first 18 years, by the time they come to retire aged 70 (which is a very likely retirement age, given the indications from the UK government), then my son will have a healthy pension pot of £343,988.76. All from just £25 per month! Increase that contribution to £50 per month and the pot increases to £687,977.52.
At £100 per month for 18 years, with 7% growth, the pot increases to £1,375,955.04
At £150 per month for 18 years, with 7% growth, the pot increases to £2,063,932.57
At £200 per month for 18 years, with 7% growth, the pot increases to £2,751,910.09
And all of the above excludes the tax relief the government will pay on pension contributions up to £2,880 per year. So, put the maximum annual £2,880 in your child’s pension pot and the government will automatically top it up to £3,600. Free money! (Source: HMRC)
But perhaps you think 7% is too optimistic a growth rate? At 5% the resulting pot isn’t as large, but it’s still pretty healthy.
At £25 per month, for 18 years at 5% compound growth, the pot would be £106,701.70
At £50 per month, for 18 years at 5% compound growth, the pot would be £213,403.41
At £100 per month, for 18 years at 5% compound growth, the pot would be £426,806.81
At £150 per month, for 18 years at 5% compound growth, the pot would be £640,210.22
At £200 per month, for 18 years at 5% compound growth, the pot would be £853,613.63
Obviously there’s the usual rhetoric that says that investments may go down as well as up, but the longevity of this investment should typically see the peaks and troughs smoothed out over time, providing a helpful nest egg for the little one. It’s also advisable to ensure that a pension isn’t your only investment vehicle, given the ever changing legislation, the currently atrocious annuity rates… not to mention the potential need of access to capital before you’re allowed to (at the moment, aged 55). None of the above constitutes advice, so do your own research if you’re reading this!