I’m 25, isn’t it too early to start a pension?
No! It is never too early to start saving for a pension. Let me explain why.
First, while the notion of a pension is most commonly associated with old age, the mechanics of accumulating for a pension are timeless. In other words, there are many factors that impact a pension and require intervention at all ages. In fact, some aspects of how pensions work are most successful when we start young.
While it is true that the taking of pension benefits is only possible for those at a more advanced stage in life such as retirement, in order to have a sufficient amount of money to live on in retirement, the rate of savings and investment growth will play the biggest role in how much money you will be able to save over time.
The most important feature of saving for a pension is the power of compound growth. In Ireland, as we save for a pension, we receive various incentives from Government to do so. The most important of those are the tax-free allowances. So, when we save towards a pension, we receive relief from tax, which is called tax-relief. Here, our total income earned is reduced by the amount we save. So, if we earn €1,000 and save €200 towards a pension, our taxable income is reduced from €1,000 to €800 with the remaining €200 being put into our pension savings account. This means that Government has not applied any tax on that €200, allowing us to keep to keep the full amount as long as we save it towards our future pension needs.
The second, and most important part of saving for a pension is the power of compound growth, this is where starting early is so important.
So, let’s take a look at some numbers.
If we take someone age 25 earning an annual salary of €35,000. Assuming for contributions of 5% of salary with an additional 5% match from their employer. Also assuming for annual wage inflation of 2% and pension growth of 5%, annual management charge of 1% of the accumulating fund and a 5% fee charged on annual contributions, by age 65, the individual should have a total fund of about €237,108. This would equate to approximately 3-times their annual salary (which should have grown to €77,000).
For this 25-year old, while their total pension fund would be worth €237,108, the investment growth share of the fund totalled €127,540 with the remaining amount, €109,568 coming from the actual contributions. Remember, half of those contributions came from the employee and half from the employer match so in reality, the total fund of €237,108 actually cost the employee €54,787 in real money and when tax relief is factored in, a lot less!
If that same 25-year old held off enrolling in their pension plan and instead, began at age 35, assuming that wage inflation was still 2%, by age 35, their annual salary would have grown to €42,664. However, as they had not signed up to a pension plan, their pension savings would be €0. Now, assuming that they did sign up to their company occupational pension scheme and contributed 5% of salary with a further 5% match from their employer. All of the same fees (5% and 1%) and growth (5%) assumptions used for the 25-year old remain in place. By age 65, the total value of the pension fund would be €161,346. Of that, €70,942 came from investment growth and €90,404 came from contributions (employee plus employer match) or €45,202 from the individual’s gross income.
So, by age 65, the person that started contributing to their pension at age 25 will have a total fund valued at €237,108 which cost them €54,787 of their gross wages. On the other hand, by holding off until age 35, the fund will be worth €161,356 and cost them €45,202.
To put this another way, by starting early, the 25-year old will have an additional €75,762 which only cost them an extra €9,585 in gross income. Plus, if we factor for 40% income tax relief it really only cost them €5,751.
This is the real power of starting early and putting the awesome power of compound interest to work.
Finally, it is important to keep in mind that a range of factors will impact overall pension performance. For example, the rate of investment growth is one major factor. Investment and management fees are another.
Frank Conway is a qualified financial adviser and founder of MoneyWhizz