June 30, 2009 12:32 pm

John Kay: Why every 2 per cent makes a difference to your pension

Compound interest, Albert Einstein is widely reported as saying, is the most powerful force in the universe. I have found no evidence that Einstein did say this – and if he believed it, which is not likely, he did not act on it.

Einstein was better at physics than at money. The Nobel Prize he received for physics in 1921 was the least valuable ever awarded, at about £250,000 in today’s money. There is still controversy over whether the proceeds disappeared in an acrimonious divorce settlement or through bad investment. But disappear they did. Einstein kept on working until he died at the age of 76.

However, the power of compound interest is the key to a long and happy retirement. If Einstein had invested his prize at 5 per cent compound, he would have accumulated a cool £2m before he died. If the great man had applied his mind to money, rather than physics, his returns might have rivalled Warren Buffett’s. The Sage of Omaha’s compound return is 20 per cent and Einstein would then have died a billionaire.

The power of compound interest results from the interacting influences of time and return. When you plan retirement savings, how long you save for and the yield on savings are every bit as important as the amount you save. The maximum tax-free pension pot the government will allow you is £1.8m. If you save for 25 years and earn 5 per cent, you will need to put aside £25,000 a year to achieve that. If you save for 45 years and earn 10 per cent, that figure falls to only £2,000 a year.

The size of pot you need depends on the number of years of retirement you plan to live and enjoy. At age 65 in Britain today, a man can expect to live for 17 years and a woman for 20 years. Life expectancy rises with education and income level, so readers of this newspaper should do better.

With that prospect in mind, turn to the yield you might hope to earn on your retirement savings. If you gathered nuts for 25 years, stored them and then planned to eat them over 25 years, you would need to set aside half your nuts for your old age. If you earn a return on your investment, you can save much less. The table below shows how much less.

Every 2 per cent you gain or lose makes a big difference. You might lose 2 per cent of return in tax, and another 2 per cent by paying more than you need in fees and charges. You can lose 2 per cent by choosing lower-risk – or what advisers will tell you are lower-risk – investments with more modest returns. You can lose much more than 2 per cent by poor investment decisions. Over the next four weeks, I and other FT Money contributors will describe how you can minimise the impact of each of these negative factors on your investment returns.

Britain has two principal tax breaks for savings: pensions and individual savings accounts (Isas). The pension rules allow you to accumulate a pot of £1.8m but with limits on what you can take out and when. There are no similar restrictions on an Isa. Next year, the annual limit on Isa saving goes up to £10,200. So, even if you only earn a 5 per cent return on your Isa savings, a couple can accumulate £1m over 25 years that way. If you can get 10 per cent, you could have more than £2m.

The effect of Isas and personal pensions together is that the vast majority of people in Britain need pay no tax on their retirement savings.

Having seen off the taxman, you must see off the sharks of the financial services industry. Buffett, the most successful investor in history – almost as successful and revolutionary at investing as Einstein was at physics – had a fortune of $62bn in 2008. In my book, The Long and the Short of It, I calculated that if he had paid the standard charges of a modern hedge fund for the investment of his money more than 90 per cent of his fortune would have ended up in his manager’s pockets.

If you are paying charges of 3 per cent a year or more – and this is easy to do – then over a long period of time it is almost certain that your fund manager will end up with a larger share of your savings than you do yourself.

But the power of compound interest could instead be working for you. The safest way of increasing your return on your investment is to pay less in fees and charges. We have shown how to do that with your pension, in this first part of our series. In next week’s FT Money, we’ll describe the range of opportunities to pay less in fees and charges on your other investments.

This article is based on John Kay’s recent book “The Long and the Short of It – finance and investment for normally intelligent people who are not in the industry,” available from the FT bookshop www.ft.com/bookshop or 0870 429 5884

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