Compounding returns: how saving a small amount adds up

Setting up your own pension fund doesn’t need to be a daunting process. With the simple steps given here you can build your own investment plan, and see how even a small regular contribution can help you retire a millionaire!

The lowdown

Building up a retirement pot may seem like a huge task, but it adds up if you break it down.

Other than the silly ‘get rich quick’ schemes promoted by fraudsters and charlatans, most financial advisors will tell you that the amount of money you retire with depends on how much money you put aside, how long you put money aside for, what return you generated on your savings, and what taxes and other costs you incurred.

No magic there.

How much you can contribute obviously depends on your circumstances, but we can work backwards and figure out how much you need to be a millionaire.

Let’s say you expect to contribute a fixed amount every year (in reality most people can contribute more over their working life) until retirement.

Let’s also say we mean a millionaire in today’s money, and not future money where a million may mean a lot less than it does today because of inflation.

Warren Buffett has said that compounding interest is the most powerful force behind his wealth and Albert Einstein called it the most powerful force in the universe.

Compounding returns many years into the future can lead to massive amounts, often far more than our intuition tells us. While we may put ‘small-ish’ amounts aside every year, compounding will turn our modest contributions into impressive sums.

To illustrate this point I made a short video on YouTube about how an 18-year-old who gives up smoking and puts the money into the equity markets can reasonably expect to retire a millionaire from the savings on the smokes alone (the same logic clearly applies to all kinds of savings).

Video: Lars Kroijer

The risks of equity

Similarly, let’s say you could put aside £6,000 every year between the ages of 23 and 67, and that you put all that money into the equity markets.

Equity markets are obviously hugely risky and you need to be able to handle that, but they have also generated a very attractive compounding interest of 5% after inflation every year. What would you end up with? Just over £1 million (ignore tax), and you would retire a millionaire.

How much would you need to put aside each year for 20 years with same assumptions to get to a million? About £67,000.

That simple?

Not quite, unfortunately. Equity markets carry huge risks and while it is a reasonable assumption that they will yield 5% compounding return, there are no guarantees. It could be far more or far less.

If you want to be more certain of retiring a millionaire you could combine your equity investment with a lower risk/return one in Government bonds or cash, but to attain the millionaire status you would need to put greater amounts aside. There is no free lunch.

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DIY investment model

While there are endless online calculators and software solutions available, it may actually be more instructive to build a simple spreadsheet yourself that is tailored to your circumstances.

Appreciating that someone who does not have decades of background in finance may find the task daunting.

You can make your annual input or the age you start at anything you like and see how things turn out.

What if you don’t need a million, but instead £10,000 per year in retirement? How much will you be left with if you put aside £1,000 a year in equities? What about £2,000? What if equities compound not at 3%, but at 6%? What if you don’t want to put it all in equities, but in lower risk asset? How would that impact your expected outcome?

But those are actually pretty random assumptions that in any case can be changed by simply entering a new number in the model.

Don't be put off!

Please don’t be overwhelmed. At the end of the day I think there is a big advantage to appreciating how simple a lot of the financial software packages really are.

I believe that when we are done with the spreadsheet you’ll understand more about your risk and what you can expect in the future than you would by studying the outputs page from an online broker, or a summary sheet from a financial planner. 

What should I invest in?

The good thing is that what you should invest in is probably much easier to answer.

Since it is overwhelmingly unlikely that you are able to outperform the stock market yourself, or pick the ‘one out of 10’ investment fund that can do so for you over a 10-year period, you should simply buy the broadest and cheapest equity index tracker you can get your hands on.

I suggest the world equity index tracker, perhaps from Vanguard. That will most likely leave you more money in the long run. If you want less risk than the equity markets, as many should, you could combine this with an investment in low-risk Government bonds or cash. Job done.

As a guide to long-term investment and return, these methods work. Don’t expect immediate gains, but the sooner you build your plan and start contributing and investing, the sooner you’ll be on the way to creating your own small fortune.

Why not opt for a self-invested personal pension (SIPP)? Compare options on loveMONEY today

Lars Kroijer is the author of Investing Demystified from Financial Times Publishing. He founded and ran Holte Capital, a London-based hedge fund, in 2002. You can follow him on @larskroijer.