The benefits of compound growth on Pensions and Investments

"Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it." - Albert Einstein

Most people assume the key to building wealth is simply saving more. While contributing regularly is important, what often has the biggest impact over the longer term is what  happens after the money is invested.

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Compound growth allows your investments to generate returns which, in turn, can generate returns of their own. Over time, this can become one of the most powerful drivers of long-term wealth creation.  

However, new research suggests many people underestimate just how much of their long term wealth could come from compound growth, particularly when it comes to their pensions.  

What is compound growth and how does it work?

Compound growth is the process of earning returns on both your original investment and any growth that has already accumulated.

For example, when you invest money into a pension or a stocks and shares ISA, your investments have the potential to increase in value. If those returns remain invested, they can generate further returns themselves.

Over time, this means your investments could grow at an increasing rate, even if you continue contributing the same amount each month.

Think of it like a snowball rolling down a hill. At first, the progress can seem slow. However, as the snowball gathers more snow, it grows larger and picks up momentum. Compound growth works in a similar way, which is why the impact is often most noticeable over decades rather than years.

The longer your money remains invested, the greater the opportunity for compounding to take effect. However, investment returns are never guaranteed, and the value of your investments can fall as well as rise.

How much of your pension comes from compound growth?

Recent research from Standard Life, based on an analysis of government figures, found that compound investment growth accounts for around £65,000 of a typical £100,000 defined contribution pension pot.

In comparison, just £18,000 comes from personal contributions, with £13,000 from employer contributions and £4,000 from government tax relief.

That means almost two thirds of the pension's value comes from investment growth rather than the money paid into it.  

It is easy to assume that the size of a pension is driven mainly by contributions. In reality, contributions often provide the foundations, while long-term investment growth does much of the heavy lifting.

Despite these facts, only 25% of people surveyed believed investment growth was the main contributor to their pension's final value. Almost two fifths (39%) thought their personal contributions made the biggest difference, while 27% believed employer contributions were primarily responsible.

These findings highlight a common misconception. Many people understandably focus on the money they contribute because it's something they can control and see leaving their account each month.

Investment growth, by contrast, happens quietly in the background. Yet over a working lifetime, it can have the biggest impact on the eventual value of a pension.

Although contributions remain essential, understanding the role of compound growth could encourage more people to think about their pensions as long term investments rather than simply somewhere to put money aside for retirement.

Why is starting early so important for compound growth?

One of the most remarkable things about compound growth is that it rewards something no investor can buy more of - time. The earlier you begin investing, the longer your money has to potentially generate returns.

Standard Life's calculations demonstrate just how much difference a few years could make.

Someone starting work on a salary of £25,000 and making minimum automatic enrolment pension contributions from age 22 could accumulate a retirement fund of approximately £210,000 by age 68.

However, delaying contributions until age 27 could reduce that figure to £170,000, leaving them £40,000 worse off in retirement.

These calculations assume annual investment growth of 5%, salary growth of 3.5%, inflation of 2% and annual investment charges of 0.75%. They are illustrative rather than guaranteed outcomes.

What makes this particularly interesting is that the difference comes from delaying contributions by just five years.  

Those early contributions have longer to benefit from potential investment growth, which can make a considerable difference over several decades.

Choosing to invest later does not necessarily mean contributing dramatically less overall. It just simply means losing five years during which money could have been working on your behalf. Over a 40-year investment journey, that lost time could be difficult to recover. 

Of course, not everyone is in a position to make substantial pension contributions early in their career. Housing costs, student loans and everyday expenses can make saving for retirement feel like a distant concern, which is entirely understandable.

The challenge is that compound growth rewards time. Even small contributions made early can sometimes have a greater long term impact than larger contributions made much later.

Are younger generations overlooking the benefits of long term investing? 

There also appears to be a generational difference in how people approach investing and retirement planning.

Standard Life's research found that 35% of Gen Z (people born between 1997 and 2012) respondents considered retirement planning something to worry about later, compared with 21% of respondents overall.

The survey found that 44% of Gen Z investors and 45% of millennials intended to increase how much they invested during the year.

It is encouraging to see younger generations taking an interest in building wealth and investing for the future. However, one of the biggest lessons from long term investing is that success often comes from patience rather than constant activity and trading. Starting to invest is important, but staying invested through different market conditions can be just as valuable. With investment performance now easily accessible through mobile apps and social media, there is a temptation to focus on short term movements in the market. As we see all the time, investors tend to focus more on the bad news, rather than the good.

While achieving strong returns is understandably appealing, focusing too heavily on short-term performance can lead investors to make emotional decisions. From our own experience at TPO, some investors chase recent winners, while others become nervous during market downturns and reduce their exposure at precisely the wrong time. Maintaining a long-term perspective is easier said than done, but it can be one of the most important factors in successful investing.

For those investing towards retirement, the real benefit may come from allowing their investments to develop over decades rather than expecting significant returns within months.

What are the benefits of compound interest on savings?

Although compound growth is particularly relevant to investments, the same underlying principle also applies to interest earned on cash savings.

When you hold money in an interest paying savings account, compound interest allows you to earn interest on both your original savings and any interest already added to the account.

This is why deciding how much to hold in cash and how much to invest should form part of your wider financial plan and not be an either-or decision. Cash can provide security, flexibility and peace of mind, while investments are typically better suited to longer-term goals due to their volatile nature. Finding the right balance between the two will depend on your specific circumstances, objectives and attitude to risk.

How can you make the most of compound growth?

Making the most of compound growth starts with investing regularly and giving your money enough time to grow. Reinvesting returns and remaining invested through periods of market volatility can help maximise the potential benefits over the long term.

Using tax efficient accounts such as pensions and stocks and shares ISAs can also help protect your investment returns from certain taxes.

In our experience, the biggest challenge for many investors isn't finding suitable investments, it's having the confidence and discipline to remain invested for long enough to benefit from compounding.

Compound growth isn't exciting. It doesn’t usually produce dramatic results overnight and it can take years before the benefits become obvious.

However, this is precisely what makes it so powerful. It rewards starting early, contributing regularly and remaining patient through periods of uncertainty.

Successful investors have not built wealth by finding the perfect investment at exactly the right moment. More often, they have simply given their money enough time to grow.

When it comes to long term financial planning, one of the most valuable decisions you can make is often the simplest; start as early as you can and let time do some of the heavy lifting.

If you’d like to learn more why not get in contact to speak to one of our expert team to see how we can help grow your wealth.

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This article is intended for general information only, it does not constitute individual advice and should not be used to inform financial decisions.

The Financial Conduct Authority (FCA) does not regulate cashflow and estate planning or tax advice. 

Investment returns are not guaranteed, and you may get back less than you originally invested.