Why is compound investing in a pension so powerful?

Compounding is one of the most powerful investing tools. But it can be particularly valuable for pension savers. Here’s how compounding works and how you could benefit.

Isabel McDougall, Pensions and Retirement Writer

Last Updated: 21 March 2024

Compound investing is when you reinvest any returns you make on your investments rather than taking the income. Any growth will multiply, and you’ll essentially earn more.

It works by allowing small amounts of money to grow into large amounts over time, like a snowball effect. It might sound complex – but it doesn’t have to be. We explore how you can benefit and provide examples of how compound investing works.

Compounding works best when you do nothing and just leave your money invested, making it particularly beneficial for pension investors. With a pension, your money is locked away until at least age 55 (rising to 57 in 2028), so you’ll be less tempted to touch your investments. By regularly investing, and letting any increases build on themselves over the long term, the results could really pay off.

This article isn’t personal advice. If you’re not sure what’s right for you, please seek financial advice.

How compounding works

Imagine that you invest £1,000 into a pension at the start of every year and that your investments grow by 5% with dividends and interest paid yearly. After one year, you'll earn £51. In the second year, you'll get 5% of £2,051, so you'll earn £105, and your savings will be worth £2,156. Fast forward by 20 years and your savings are worth £35,188 compared with overall contributions of £20,000.

This is an example only. Actual returns will vary depending on the investments you choose. These calculations don’t take into account charges or taxes. The value of investments can go down as well as up in value, so you could get back less than invested. The compound interval is on a monthly basis.

Don’t forget about pension tax relief

It’s not just compounding that can help you reach your retirement goals more quickly. You’ll also get a boost from the government. Each time you add money to a pension, the government also automatically adds 20% in tax relief on top of what you pay into a pension. This means that a £1,000 contribution could effectively cost you as little as £800.

If you’re a higher or additional rate taxpayer, you could also claim back even more through your tax return. Pension and tax rules can change, and benefits depend on your circumstances.

More on pension tax relief

How to benefit from compound investing

The best thing about compounding is that you don’t really need to do anything to benefit from it once you start. So long as you check that you’re diversified enough and your investments are still in line with your goals, time will do the work. And one of the best ways to start benefiting is by investing monthly.

Why invest monthly?

• It takes the emotion out of your decisions

  
  The stock market will always go up and down, and you’ll always want to buy when the price is low and sell when it’s high. If every investor could do this successfully, the world would be a very different place. Investing automatically gets you out of the mindset of having to ‘time the market.’

• You’ll benefit from ‘pound-cost averaging’

  
  Investing automatically helps smooth out the bumps in the market, taking the emotion out of your choices and spreading your money across different market conditions. Sometimes, you’ll buy at a higher price, and other times it could be lower – but you won’t have to worry about the timing. Over time, these ups and downs tend to average out.

• It’s good investing discipline

  
  Setting aside money automatically makes it easier to get into good habits. You won’t forget to invest because it happens at the same time every month, and any growth will compound upon itself. Leaving the money alone can be hard and takes patience, but the results can really pay off over time.

More about investing monthly by direct debit

How early should I save and invest in my pension?

The earlier you start investing, the sooner you could start to earn interest or dividends and start seeing compounding work for you.

For example, if at age 30 you start saving 12% of a £30,000 salary, your pension would be worth around £202,000 at age 67. If you don’t start a pension until age 45 and pay in the same amount (12% of a £30,000 salary), you would build a pension worth only around £101,000 by age 67.

These figures take account of inflation and show the buying power of your pension in today's money. They assume a growth rate of 5%, charges of 1.5%, and that your salary (and so pension contributions) increases by 3% a year.

If you choose to invest, your money also has more time to grow and benefit from the phenomenon that is compound investing. Remember, though, investments could fall as well as rise in value, so you could get back less than you invest.

How much should I pay into my pension?