Thanks to the awesome power of compound interest and a little known fact about pension contirbutions, you can make your child (or grandchild) very, very rich indeed.
Did you know that you can invest in your child's pension before he or she is out of nappies?
Remarkably, the Government allows anyone under the age of 75 to contribute to a pension, tax-free - and it doesn't have to be their own.
Pensions for children
So, generous parents, grandparents, godparents and other relatives and friends can contribute to your child's pension. These contributions earn tax relief of 20%, even though the child is unlikely to have paid any tax at all. As you'd expect, there is an upper limit on how much you can invest each tax year. By paying in a net £2,880, you receive £720 in tax relief, making a gross amount of £3,600.
As I explained in Make Your Child A Multi-Millionaire, I invest the maximum amount each year into low-cost self-invested personal pensions (SIPPs) for my son and daughter. Although I'm probably being over-generous, I know from my own experience how difficult it is to put money aside for retirement when you're a young worker - and yet that's when, ideally, you should start making contributions.
So my aim is to make the early years of my children's careers easier by bringing forward their retirement saving.
The awesome power of compound interest
Some people claim that Albert Einstein once described compound interest as `the greatest mathematical discovery of all time', although this may be a myth, according to urban-legends website Snopes.
Nevertheless, compound interest is -- without a doubt -- the investor's greatest friend. It works like this: when you invest money, you make a return on it. In the next year, you make a return on both your original sum and your first-year return. In the third year, you make a return on your original investment, plus two years of returns. The process of earning gains on previous gains is what makes compound interest so powerful.
How to make compound interest work for you
Here at the Fool, we came up with five rules to make the most of compound interest:
1. Start early, as the earlier you start investing, the more time you have for compound interest to work in your favour.
2. Small differences in annual returns make huge differences over long periods. The difference between, say, earning 5% a year for 25 years and 10% a year over the same period is massive.
3. Small amounts can build big pots. For example, investing £100 a month at an annual return of 10% will produce a pot worth £559,461 after forty years.
4. To feel the full benefit of compounding, you need time and patience. Saving for twenty years is far better than saving for ten years.
5. When your boat finally comes in, don't splurge your life savings too quickly!
How big could a child's pension become?
Family members with deep pockets may be willing to set aside serious sums in order to give a child a better future. Let's say that a generous parent is willing to contribute the maximum £3,600 into a child's pension. This comes to £300 a month, or £240 a month before tax relief. Now let's assume that mummy or daddy pays this sum from a child's birth until the son or daughter reaches the age of seventy. That's one big-hearted relative!
So, here's how £300 a month builds up over seventy years (here comes an extreme example of the power of compounding):
Annual return (%) | Pot value (£) |
|---|---|
3 | 843,567 |
5 | 2,175,656 |
7 | 6,028,935 |
9 | 17,429,205 |
11 | 51,519,544 |
13 | 153,739,611 |
15 | 459,477,799 |
17 | 1,368,464,250 |
As you can see, a modest return of 5% a year would produce a pot worth almost £2.2 million after seven decades. At 11% a year, the total soars to £51.5m. Finally, with a market-thrashing return of 17% a year, our septuagenarian has a cool £1.368 billion to retire on!
Now for the bad news: it is incredibly unlikely that an average return of 17% a year for seventy years is attainable. My guess is that high single-digit returns (perhaps around 9% a year) are more likely. Furthermore, after seventy years of rising prices, inflation will have wiped out the vast majority of your pot's buying power. All the same, in the words of Sir Winston Churchill:
"Saving is a fine thing. Especially if your parents have done it for you."
Many thanks to Fool reader and expectant father Jason for inspiring this article.
More: Visit the Fool's pensions centre | The £100 Billion Pensions Bonanza | Make Your Child Wealthy