It’s not how much you save, but how long

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Long Term Savings – the need to start early

Saving for income in retirement can be a daunting thought for most people – the problem they face is that they simply don’t know how much they need to save between now and retirement.

In this article we consider the time value of money, and in particular, the benefits to be enjoyed from “compound growth”. In later articles we consider just how you go about working out how much you need to invest to plan for your own retirement income.

The Rule of 72

In the article “The Rule of 72 – the Time Value of Money” we discussed a simple technique for calculating how your money grows over time whereby dividing the rate of growth you are enjoying on your money into 72 shows the number of years it takes for your money to double in value.

For example – if you were lucky enough to receive 6% annual interest on your money in a savings account then this would double in value every 12 years (72/6=12).

Compound Interest

The principle of compound interest is simply one of “money makes money”. An example of this would be investing £100 in a savings account at 10% interest – after one year your money would have grown to £110 – after two years, £121 – you have earned an extra £1 interest in year two as not only have you earned 10% on your original investment of £100 but you have also earned 10% interest on the £10 interest you made in year one and this continues for as long as you leave that money invested.

Over time, as the proportion of “interest earned” grows then the rate at which your overall investment grows also increases – it’s like a snowball effect – when you roll a small snowball down a hill at first it grows slowly – the more it rolls, the more snow it picks up on each rotation and the faster it moves…….

The following chart shows how £500 per month, enjoying a simple return of 5% per annum, grows over a 30 year period –

Demonstrating compound interest on regular savings over time

The above chart shows that in the earlier years the rate of growth on the funds invested is relatively low, and as the benefits of compound growth accumulate over time the curve of the graph becomes steeper as each and every £1 of interest earned subsequently earns its own interest!

It’s not how much you save, but how long….

The principle of compound interest therefore brings us nicely into the subject of pension planning, saving for retirement or any other form of long-term saving.

For the sake of this example we will consider that you wish to retire at age 60 and you are now aged 30.

You have calculated that to provide income in retirement of £20,000 per year, ignoring inflation for the time being, and assuming a return of 5% after charges for both the growth on your money being invested BEFORE retirement and for the annuity income you receive AFTER retirement, that to provide £20,000 per annum you need a fund of £400,000 (£20,000 per annum divided by 0.05).

So to achieve this income goal you need to build up a fund between now and retirement of £400,000. Logic says that we simply divide the fund needed between the number of years to retirement and this tells us how much we need to save each year – in this example £400,000 over 30 years requires a saving of £13,333.33 per year (£1,111.11 per month)

This however doesn’t take into account the growth that you would enjoy on each contribution being paid into the investment vehicle – the contribution made in month 1 would have the longest time to grow – 29 years and 11 months, the contribution made in month 2 – 29 years and 10 months and so on…….

Compound Growth and Regular Savings

Saving on a regular basis into an asset-backed investment, such as a pension fund, or a unit trust held under an ISA umbrella, can benefit from “pound cost averaging”. In a volatile stock market, such as the one we are currently in, investing on a regular monthly basis means that you effectively have 12 chances each year to invest some of your money into the stock market on a day when the market is lower than on other days. The benefit of this is that it brings down the average cost of the units you hold, and ultimately leads to a larger potential profit at the end.

In our example above we calculated the monthly contribution required to build a fund of £400,000 assuming no growth

If we add in say net annual growth of 5% after charges (which should be achievable over the medium to long term) then the monthly investment actually falls to £480.62 per month.

If the rate of growth increases to say 6% per year, the monthly investment falls to £398.20 per month.

If the rate of growth again increases to say 9%, the monthly investment required to hit £400,000 falls to £218.49.

The Cost of Delay

Above we calculated that £480.62 invested at 5% net per annum will grow to £400,000 over a 30 year period. If we reduce the term to 29 years, then to achieve the same fund value, the monthly investment needs to be £512.77 per month – an additional monthly investment of £32.15 or an additional total investment of £11,188.20 over the life of the investment. This shows the cost of delay.

So by waiting one year, an additional £32.15 per month needs to be invested, each and every month for the whole 29 year period, to provide the same £400,000 fund at age 60.

If the individual were to delay their regular savings by 2 years then a monthly investment of £547.63 would be needed – delay by just 5 years and the monthly contribution rises to £671.69 which is probably beyond the means of most families with average income and outgoings.

Starting Early

We have now calculated that the regular saving to build a fund of £400,000 over 30 years, at 5% net return per annum, would be £480.62 per month – but what if you were to start earlier?

If you had the foresight to have started last year, and therefore have a period of 31 years over which to make this investment then this monthly investment would fall to £450.90 – start 5 years earlier and the monthly investment would need to be £352.08……………….

Conclusion

In conclusion then it is vitally important that you start saving as soon as possible for retirement income – whether that be through a personal pension, stocks and shares ISA, a deposit account…….

Start as soon as possible!

Ask yourself this question – how many more paydays until retirement? – 30 years – another 360 payslips – it’s later than you think!

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Trusts – Protecting Wealth and Financial Planning

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Trusts – An Introduction

This article is an introduction to Trusts and how they can be used in financial planning to achieve your money and wealth goals not only as a tax planning tool but also to protect your existing wealth.

What is a Trust?

A Trust is any arrangement whereby one person(s) manages and looks after assets for the benefit of another person or people. It is a legally binding agreement and is covered by various Trust and Taxation laws as well as judicial precedent.

Who is involved?

There are three classes of person involved in the setting up of a Trust – a Settlor is the person who sets up the trust, normally to receive their own assets – the trust assets are looked after by the Trustees for the ultimate benefit of the Beneficiaries.

During the term of the Trust, the Trustees are the legal owners of the Trust assets but the Beneficiaries are the beneficial owners. It is the Trustees legal responsibility to ensure that all decisions made in respect of Trust assets are made in the best interests of the Trust’s Beneficiaries.

It is normally good practice to have more than one Trustee and in the majority of cases the Settlor will also be Trustee. In line with this, it is also possible to name direct individuals to be Beneficiaries under a Trust or this could be written into the Trust to cover a group of people – for example, “all my children who survive me by 28 days”.

How is a Trust set up?

A Trust is generally set up by completion of a Trust deed. This deed sets out the nature of the Trust, the Beneficiaries of the Trust and the powers and obligations of the Trustees.

In respect of life insurance policies generic Trust wording can usually be supplied by the life office to help the Settlors’ legal representative ensure that a correctly worded Trust is put in place.

Are there many Different types of Trust?

Yes – there are a number of different types of trust and they all have different purposes – further information on the different types is available from your Solicitor – the purpose of this article is to introduce you to the topic of Trusts and how they can be used in relation to your own personal financial planning. In future articles we will deal with some of the more common Trust arrangements in more detail

How are they used in financial planning?

Two of the most common uses for Trusts in financial planning are to protect assets from taxation or creditors or to ensure that assets pass to the correct beneficiary in the event of the death of the Settlor.

The majority of people reading this article may come into contact with a Trust arrangement through taking out a life assurance policy.

The Settlor, who is also usually the life assured, sets up the Trust using a standard wording provided by the life office (which it is advisable to get checked by a suitable qualified Solicitor) to leave the benefits from the policy (the sum assured) for the benefit of specific individuals.

A normal course of action would be for a parent to effect a life policy and place it in Trust for their children. There are several benefits to this course of action:

1. The sum assured on death is outside of the deceased’s estate and is therefore not normally subject to Inheritance tax.
2. The proceeds from the plan can normally be paid out quicker as there is no need to wait for probate to be obtained to allow release of funds. Usually provision of the death certificate and a copy of the Trust is all that is required.
3. It stops third parties accessing the funds which may not be what the life assured intended – it’s amazing who can “come out of the woodwork” when someone dies and there is money to be shared out!
4. It stops the sum assured being used to repay debts of the life assured in the event of the life assured dying whilst being insolvent or having large debts.
5. If the Beneficiaries are young children then the money can be held within the Trust and the Trustees would usually have the ability to make advances of the funds for the welfare and benefit of the children, whilst retaining the monies until the children are older and better able to manage their own affairs.
6. Grandparents could utilise a Trust to allow their assets to effectively “skip a generation” and be passed to grandchildren which is a particularly popular arrangement where their children are already wealthy in their own right.

What about Tax Planning?

Yes, Trusts can also be used for tax planning and in later articles we will discuss the various Trust planning tools available in the UK today. Gifts can be made into specific Trusts which provide an immediate saving against Inheritance tax; other Trusts exist to remove growth of investments outside of an Estate whilst still allowing the Settlor access to their capital.

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Pay Yourself First – the first step in wealth creation

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One of the key principles of personal financial planning and wealth creation is to live within your means. This does not mean “going without” – it simply means to only buy what you can afford to buy.

Pay Yourself First

“Pay Yourself First” is a principle of wealth creation which I first came across in the fantastic book on wealth creation “The Richest Man in Babylon” by George S. Clayson and is a principle which has been repeated so many times through the ages.

Simply put, every time you receive any income, take a portion off the top BEFORE you spend any of the money on anything else and save it or do something constructive with it.

The book talks about taking 10%, but I feel in reality you should start small, say 5%, and allow your lifestyle to adjust to your new level of disposable income before increasing the amount you save. If done in small increments, the amounts you save each month will not feel as “painful” – you are less likely to miss another £10 per month taken from your income, than you are £100.

For example, if you earn £30,000 per annum, in the UK today you are taking home £1,800 per month after tax and national insurance contributions. 5% of this would amount to £90 per month. If you invested this £90 per month, and achieved a return of say 4% per annum, after tax and all charges, which would be conservative, then after 5 years you would have amassed £5,966.

Now let’s be honest, this £90 is not money which would have been spent on necessities but is money which would most likely would have been “wasted” on non-essentials. Here are some of what I consider to be the worst value items which people genuinely purchase on a regular basis:-

  • Per-packed sandwiches
  • Bottled water
  • Newspapers
  • TV listing guides
  • Gym memberships (and then stop attending after a few months!)

I am sure if you analyse your own expenditure you will identify those areas in which you “waste” money.

Repaying Debts – a form of “saving”

Alternatively, if you are currently carrying any debts, such as credit or store cards, consider redirecting this waster money into repaying those debts. With credit cards charging considerably high interest rates, by repaying these first you will be earning a far better return on your money.

For your Consideration!

Buy and read the book “Richest Man in Babylon” – it is an excellent read and is not an expensive purchase.

It is a worthwhile exercise to analyse your income and expenditure to see exactly where the money comes from and goes to each month.

Consider setting up a standing order from your current account into a savings account – many banks these days offer online “electronic savings” accounts, which pay a higher level of interest than your current account – simply set up a regular payment to take some money from your current account and place it in your savings account each and every month.

The other benefit of these types of account are that you don’t need to visit the branch – saving both time and money.

The best time for this payment to be made is just after payday!!!

We would appreciate your comments and experiences on this topic – feel free to comment below.