Accelerated savings

Accelerated savings

Read Time: 4 minutes

Image by WikiImages at Pixabay.com

Back in the early days of my career, I attended a course with a chap whose name now escapes me but who shared with me what seemed like an interesting idea. It takes advantage of the fact that with any long term saving exercise, the impact of compounding is such that the contributions made in the early years have the most impact, as they are invested for the longest period. The drawback is that there is actually less money invested at that point as most is still to come, so it is less beneficial than it might be.

He therefore suggested that it would be worthwhile to maximise the amount invested in the early years and then suspend or reduce the amount invested later.

One drawback to his proposal (which he neglected to mention) was that this was in the 1980s, when the financial services marketplace was a bit different. In particular, product costs were notoriously opaque and (not entirely unrelated to that) generally pretty high. Although charges were levied throughout the lifetime of a product, there was considerable ‘front end loading’. This meant that a substantial chunk of the investor’s contributions in the early years were hoovered up in costs by the provider. Some of these went to fund commission payments to what were euphemistically called ‘advisers’ and my acquaintance was apparently one of the most productive of them.

However, several decades of progress in financial services mean that we now live in more enlightened times and this makes such a strategy more feasible.

There are two reasons why it works and they both relate to the power of compounding. Those savings invested early have more time to grow than those invested later and it is much easier to make use of compounding than it is to restrict expenditure now in favour of saving. The first reason does rely on the assumption that over your investment time horizon, returns are positive on average (another reason to take a long-term view of such matters and to be highly diversified). However, the second is more of a behavioural issue. Even though we might rationally appreciate that saving money now is something that we should do as a hedge against an always uncertain future that does not make it easy, particularly when there are other calls on our resources. If creating freedom from paid work involves establishing a passive income (make money while you sleep), compounding is the investing equivalent of this.

Naturally, it is worth making the point that saving early in your career may not be easy, particularly if your income is low. However, it is a good habit to get into and armed with the knowledge of how much impact it can have, you may make different choices as to how you allocate that income.

By way of illustration, consider the situation of two individuals. One elects to save £10,000 each year for 10 years and then never saves again for the next 25 years. The other waits 10 years and then starts saving £10,000 each year for the next 25 years.

Source: Bloomsbury Wealth

Assuming an average annual return of 6%, the first ends up with a fund of around £600,000. For the second, despite saving two and a half times as much, they still end up with around £20,000 less. The difference is therefore entirely a function of compounding.

These figures take no account of inflation or changes to earnings so are inevitably a simplification of the real world but so are all models designed to illustrate a principle. They are also highly sensitive to the rate of return assumed. The higher the return, the greater the benefit of starting early; the difficulty that anyone faces when trying to decide between the two approaches though is that none of us has any reliable basis for determining what returns will be in the future.

Another illustration of the importance of time when saving can be seen in the proportion of the final pot which derives from each year’s investment. Taking an example of someone who saves the same £10,000 every year for the whole 35 years and achieves the same average annual 6% return, we can see that although each investment amounted to 2.8% of the total saved (horizontal line), none of those made in the last 20 years amounted to this proportion of the final fund while the first year’s accounted for over 6% of it.

Source: Bloomsbury Wealth

Furthermore, half of the final £1.18m is actually accumulated from those savings made in the first 10 years.

Source: Bloomsbury Wealth

What this means is that the savings made in the later years have considerably less impact than those made earlier.

Inevitably, despite its mathematical attractions, a strategy in which you concentrate your savings in the early part of your career is not going to be for everyone. There is more to life than accumulating financial capital and the prospect of spending our 20s living like a hermit while our friends and colleagues are actually living, forming relationships and starting families may not sound that appealing. However, it need not be an ‘all or nothing’ approach and even if you are only able to implement it partially, when the expenditure increases later in life (mortgage, education costs, supporting ageing relatives etc.) you may be grateful that you made some sacrifices earlier. If nothing else, at least you will have had a head start when it comes to funding your post-work lifestyle costs so that is one area of your life which will require less mental energy at that stage.