Wednesday 19 September 2018

Start early and 10 years' savings will be a nest egg

Illustration by Tom Halliday.
Illustration by Tom Halliday.
Louise McBride

Louise McBride

A 21-year-old is more likely to open a bottle of beer than a savings account on their birthday – however, save for 10 years from the age of 21 and your savings could be worth more than a late starter who saves for 40 years.

Compound interest – which is essentially interest earned on interest over time – is the reason.

Compound interest makes a deposit or investment grow faster than it would normally. To really benefit from compound interest, you must start saving early. The investment return earned on your savings each year must also be strong.

So when does it pay more to save for 10 years than 40?

Let's say you start saving €3,000 a year into a investment fund at the age of 21.

You save for 10 years. Although you stop saving after 10 years, you leave your savings in the fund until you reach the age of 70.

By the age of 70, those 10 years' savings would be worth €664,129 – as long as the annual investment return on your fund is seven per cent, according to Ian Mitchell, a pensions expert and managing partner of the Belfast consultants, Eighty20Focus.

However, let's say you put off saving into the fund until the age of 31. You save €3,000 a year and continue doing so for 40 years. The annual investment return is also seven per cent. In this case, your fund would be worth €640,829 by the age of 70, according to Mitchell. That's about €23,000 less than it would have been worth had you started at the age of 21.

Furthermore, the €664,129 nest egg you built up by saving for 10 years from the age of 21 only cost €30,000 of your hard-earned cash. By contrast, the €640,829 lump sum built up after saving for 40 years cost you €120,000. There is one big caveat – it will only pay more to save for 10 than for 40 years if the investment return earned on your savings each year is strong.

"The average annual interest rate needs to be both consistent and around seven per cent if 10 years' savings is to provide a bigger pension pot or nest egg than consistent lifetime saving," said Mitchell.

Ten years' savings is unlikely to be worth more than 40 years' savings if the annual return is only four per cent – even if you start early.

Save €3,000 a year for 10 years from the age of 21 and those savings will be worth €179,842 by the time you're 70 – if the investment return is four per cent a year, according to Mitchell. However, save €3,000 a year for 40 years from the age of 31 and your savings will be worth €296,480 – that's €116,000 more than the early starter.

Drawbacks for early birds

There are also downsides to saving early. "The effect of a market downturn is significantly greater on an already accumulated pot than it is on a slowly accumulating pot," said Mitchell.

For example, were stock markets to dive by 20 per cent when an individual reached the age of 45, that individual would be better off retiring with 40 years' savings which he started paying into in his 30s – than retiring with 10 years' savings started in his 20s, according to Mitchell.

Inflation can also work against early birds. "When you take inflation into account, the value of the annual €3,000 contribution reduces significantly in real terms over time, thus making each contribution considerably more expensive for the early saver than the later," said Mitchell.

Compound interest can, however, offset inflation – if the investment return is high enough to beat inflation, according to Gary Connolly, the managing director of the investment consultants, iCubed.

"Early starts are better than late starts – because with an early start, you maximise the time for compound interest to work," said Connolly. "Under reasonable assumptions, someone who starts investing at the age 25 and invests for ten years does better than someone starting at 35 and contributing for 30 years until retirement."

Use the children's allowance

If you have young children, or are just about to give birth, don't underestimate the value of saving their first few years' child allowance.

Your child could have a pension worth €194,500 by the time he reaches 70 if you save his first two years' child benefit payments – and that money is then left in a pension until he reaches the age of 70, according to Connolly.

To get this €194,500 nest egg, the child benefit rate – which is currently €130 a month for each child – would need to remain unchanged for the next two years. Connolly's figures assume an investment return of six per cent a year – so if the return is only a fraction of that, the lump sum will be a lot smaller.

"If you continued to save the child benefit payments for three years instead of two, and then left that money in a pension, that fund would be worth €276,000 by 2084 – that's a huge difference for an extra €1,560 in savings," said Connolly.

How to be an early bird – and feast on worms

To be an early bird saver whose 10 years' savings beat those of a later starter, the investment fund or product that you put your savings into must deliver an annual return of at least 7 per cent a year – according to Ian Mitchell of Eighty20Focus.

Finding an investment fund that will consistently deliver returns of at least 7 per cent a year is hard but if you can master it – or find a fund which delivers an average annual return of 7 per cent while you have your money invested there – you will get the full benefit of compound interest.

The Sunday Independent asked Vincent Digby, the investment expert and founder of Impartial, to recommend some funds that could deliver strong annual returns over the next few years. He tipped three funds:

* Standard Life's Synergy Euro Smaller Companies

This fund, which invests in the shares of smaller companies listed on European stock markets, delivered an annual return of 25 per cent a year over the last five years, says Digby.

* Merrion Irish Opportunities

This fund invests in the shares of Irish firms – or companies with substantial business interests in Ireland. It delivered an annual return of about 22 per cent over the last five years. "If you still believe in the Irish recovery story, this fund could be worth investing in," said Digby.

* Standard Life's Synergy UK Smaller Companies

This fund largely invests in the shares of smaller companies listed on the British stock market. It delivered an annual return of about 25 per cent over the last five years.

It is important to view these five-year returns in the context of the stock market rally of the last five years – which will come to an end at some stage.

Vincent Digby also searched for investment funds which have delivered returns of at least 7 per cent a year over the last 10 years. Amongst those which have are: Aberdeen Asset Management's Global Emerging Market fund; Danske Invest's Global Emerging Markets Fund; the Prescient Alternative Investments fund; the MLIIF Latin American fund, and Aberdeen Asset Management's Global India Equity fund. The same caveats about past performance apply to these funds as the earlier ones recommended.

"None of these funds delivered returns smoothly each year over the last 10 years," said Vincent Digby. "There were very good years and very bad years."

Remember, past performance is no guarantee of future gains. "The only thing that matters is where these funds are going from now," he said.

If you are a long-term investor, you need to hold your nerve through market downturns in the hope that market upturns will smooth out your returns. Equally, however, it's important to choose your investment funds wisely. Pick the wrong one and you could lose all your money.

As you approach retirement, move your money into low-risk products to ensure everything isn't wiped out should a stock market crash hit just before you retire.

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