In a world of never-ending ‘austerity’, making each pound stretch the best it can is everything.
It truly baffles me how far we have come with efficiencies of computers, cars, trains and manufacturing, yet prices just seem to keep rising.
It’s almost by design.
So, as we save into pensions, or our ISA’s, are there any quick-fire tips to make our money work the most efficiently?
Bear with me on this, a subject as exciting as a cardboard licking competition, because the importance of starting your pension contribution early is quite critical.
The first time I saw the following calculation was over 30 years ago when a financial adviser was boring me senseless with why I should be taking out a pension. He was my manager!
Back then, the first 4 years of your pension contributions evaporated on paying commissions and fees, but those days are thankfully long gone.
I’ll use an example of a 20-year-old starting a simple pension of £50 per month all the way through their life to age 65. The final pension fund adjusted for inflation comes to £48,046 which is a 77.9% return on each pound invested. Seems a good deal?
However, if I look at the impact the first five years has, it’s quite astonishing. The actual return on the first 5 years investments is 196%, quite simply because of compound growth. The first year has the longest time to compound, and that returns 215%, so you can therefore see how important an early start is.
Albert Einstein – a bright chap in his day – cited this principle of compounding as the most powerful force in the universe.
With that in mind, many grandparents might be inclined to contribute into a stakeholder pension as early as is possible after a child is born, as this adds an extra twenty years onto the above calculations. The return hits a staggering 514% for that one-year contribution.
Moreover, the grandparent/parent attracts tax relief on their contribution, so the maximum permitted to a stakeholder scheme of £2880 becomes £3600, an immediate guaranteed increase of 25%.
Parents and grandparents wishing to make a contribution of such amounts would also be helping their own Inheritance Tax (IHT) situation, as the above would be classes as gifts out of normal expenditure.
As long as they are regular and out of normal income, and leave the transferor with enough income to live on, the money transferred into the child’s pension are a valuable exemption from IHT.
Another method of making the most of your contributions is to avoid trying to time markets.
Pound cost averaging is the strategy of making regular monthly investments to take advantage of volatile markets.
At the moment, money is typically invested across some variant of an investment fund.
That fund (as a simple example) has money spread across a wide range of companies. What you are effectively doing is buying a ‘share’, or unit in those shares.
If the share price is £1 and you invest £100 per month, you are buying 100 units/shares. If the value of those companies falls by 10%, the price is 90p and you are now buying 111 units/shares.
The following month, the market recovers to normal and your 111 units are now worth £111.
This pound cost averaging strategy is counter intuitive to many. As markets fall, it is seen as ‘bad’ and as they rise, it is seen as ‘good’. Neither of those measures are true.
As the variation of the saying goes, there is no such thing as good or bad, it’s your thinking that does that.
The reality is that when markets fall, unit prices fall, and that is the time to increase contributions or even push in the lump sum and acquire units at the cheapest price possible.
You could say that pension investing is about acquiring as many of the cheapest units as is possible.
‘IF’ you can keep your head whilst all around you are losing theirs…
(Story source: 50 Connect)
