#8 - Understanding How Pensions Grow
Explaining the only factors that matter when it comes to pension calculations
When people talk about pensions, it’s easy to get overwhelmed by the terms and the calculations. But most of what matters depends on just a few factors. Here’s what they are, and why they matter…
I’ve previously written about How Pensions Work and the main Types of Pension. Now we look at how pension funds grow over time. This is really important for all private pensions and most occupational pensions since it’s virtually impossible to actually save enough for retirement without factoring in some investment gains. It’s less relevant for public sector or state pensions.
It goes without saying that you want your pension fund to be as big as possible. A bigger fund means you can retire earlier, draw a larger annual pension, and have more flexibility in lots of other areas too. Many factors affect the size of your fund, but they can almost all be summarised in four categories. Three of these make your fund bigger (and hence are good), and one makes it smaller (and hence is bad, but unavoidable!).
Contributions
Unsurprisingly, the size of your fund depends a lot on how much goes into it - don’t expect much if you don’t save much! Contributions can come from you personally and/or from your employer, so make sure you’re maxing whatever your employer offers. Your personal contributions benefit from BIG tax savings (future post coming on this) and will cost you a lot less than you think. Even if you can’t afford to save much now you’ll be surprised how it adds up over time (especially if you’re in your 20’s or 30’s), and there are some smart techniques to increase your savings as your future income increases. High returns can compensate if you can’t afford to save much or if you start late, but chasing high returns is risky, far from guaranteed, and can end badly.
Simple advice - start as early as you can, save as much as you can, and make sure you benefit from the max your employer offers.
Returns
Returns have a major impact on how big your fund gets, and how quickly. It’s not unusual to see returns end up being many multiples of the amount actually contributed. There’s a strong link between risk and return and younger people are usually advised to take higher risk to benefit from higher returns since any possible losses have many, many years to recover before they retire. For example, while some stock markets painfully lost half their value in the financial crisis a decade ago, they have rebounded five times over since then! Older people usually switch to lower risk investments as they get closer to retirement. But it’s important to remember that maximising returns is HARD. The entire global finance industry tries to do this and even they don’t do much better than average.
Simple advice - take risk appropriate for your age but otherwise don’t sweat about chasing returns since they’re outside your control. Instead focus on contributions and time, which you have more influence over.
Time
Least exciting and often overlooked (people don’t get excited about getting rich slowly!), time is entirely within your control and has enormous impact on how big your fund grows. I’ll write a future post getting into the detail on this, but let me leave you with the following example for now. 90 year old Warren Buffett is one of the greatest investors of all time but most of his wealth is due to his incredibly long investment timeframe. He has been investing since his teens and even though he is worth over $100 billion today, he has made 99.7% of that return after his 52nd birthday and 95% of it since he turned 65. Time matters!
Simple advice - the best time to start investing was 10 years ago. The second-best time is now.
Fees
It’s no surprise that fees are bad. Compounded over time, you’ll be shocked at the impact of even small annual fees. Watch out for once-off fees on contributions to some investment products, as well as the recurring annual fees. But apart from being aware of them, and ensuring you’re not being ripped off, there’s very little you can do here.
Simple advice - all else being equal, lower fees are better, especially recurring annual fees.
In reality, dealing with your pension fund will be a little more complex than outlined here, and you’ll have to make choices on a few other areas (choice of investment funds, for example). But this is nevertheless a good framework to help put everything in context and approach the decision with more confidence. I’m planning quite a few more posts to expand on these areas, so subscribe here to get them delivered straight to your inbox.
Let me leave you with a final thought. Everyone likes the idea of high returns but since so much of this is outside your control it’s much more prudent to focus on the things that are, namely (i) saving more, or (ii) allowing time and compound interest to work their magic.
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