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Using Dividend-Paying Assets to Build a Pension Pot

By contributing early and often to an investment plan, an investor's money compounds over time. Compounding accelerates the growth of your assets over time

Morningstar News Team 9 October, 2015 | 10:30AM

This article is part of Morningstar’s Guide to Income Investing. Whether you are looking grow your pension pot, or invest for retirement income, this week we have all the news, information and education you need.

Approaching retirement with too little money is unfortunate. Furthermore, getting sucked into the daily hype that has people jumping in and out of the stock market can be disastrous. The market will inevitably go down once in a while, but history proves that despite this, the long-term trend for the market is up. Taking that into account, the earlier an individual begins to invest, the better.

Data indicates that the savings rate has fallen since the credit crisis. Most people simply aren’t saving enough for retirement, in an era when even more responsibility for retirement savings has been shifted from corporations to individuals.

This long-term lack of savings is partly a cultural phenomenon. Baby boomers have a stronger sense of optimism than the World War II generation, and have not placed the same priority on saving. Worse yet, they have relatively easy access to credit and a habit of spending beyond their means, regardless of how much money they make. This trend continues in subsequent generations.

The problem is that people should be saving more; the move from defined benefit workplace pension schemes to defined contribution schemes means a reduction in retirement income and state benefits are being squeezed every year. The good news is that people have started to realise this recently.

By contributing early and often to an investment plan, an investor's money compounds over time. Compounding, otherwise known as the ability of an asset to generate earnings from previous earnings, accelerates the growth of your assets over time.

How Does Compounding Work, Exactly?

Let’s say you begin in year one by investing £1,000. Year one proves to be an exceptional year for the market, and your investment returns 12%. You now have £1,000 + £120 = £1,120. Year two, however, is not so great, and your return for year 2 is now only 7%. The power of compounding is that you have now gained not 7% of your principal value (7% of £1,000 = £70), but 7% of your total investment value at the beginning of year 2: 7% of £1,120 = £78.40.

Now imagine what continuous compounding over a longer period or time can do. The image below illustrates the growth of an account based on an investor’s age and the amount contributed annually until age 65. The 30-year-old investor contributing £8,000 per year will have nearly £1.5 million at the age of 65. This is more than double the ending wealth value of an investor who saved the same amount per year but waited until age forty to begin saving.

It is quite clear that the earlier you start and the more you invest, the easier it is to achieve your retirement savings goal, thanks to the power of compounding investment returns. But all is not lost for investors who do not start to aggressively save for retirement until they reach their forties or fifties.

The good news for these investors is that they still have enough time to change their savings behaviour and achieve their goals, but they will need to act quickly and be extremely disciplined about their savings. Time waits for no one, so don’t procrastinate—get started now.

A version of this article first appeared on Morningstar.com. It has been edited for UK investors

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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