Investing for retirement is a common long-term financial goal for many individuals. The core idea is to regularly set aside a small amount of capital from each monthly paycheque into a retirement account.

Typically, professional retirement planners recommend putting aside 10% to 15% of gross income each month. That way, when the time comes to stop work (the average retirement age is 65), there is a sizable nest egg to cover all future financial obligations.

Saving vs investing for retirement

While the terms “saving” and “investing” are sometimes used interchangeably, there is a stark difference between the two.

• Saving – Depositing money into a bank account that can be readily accessed, receiving a small amount of interest each year. Bank accounts are exceptionally low risk with many regulatory protections for depositors’ money in the case of a sudden bankruptcy. However, the interest received on deposits has historically struggled to stay ahead of inflation, resulting in the destruction of wealth in real terms. Cash savings provide a buffer to cover living expenses, gifts, holidays, and emergencies.
• Investing – Put money to work through an investment vehicle, such as stocks, bonds, or mutual funds, to attempt to build wealth in the long run. Depending on which asset class is used, successfully investing capital over long time horizons can build enormous wealth and pave the way for a comfortable retirement. However, unlike a savings account, investment instruments are typically less liquid and carry risk. A poorly constructed retirement portfolio could destroy wealth rather than create it.

Both retirement saving and investing have an important role to play in a retirement plan. But investing prudently is where the primary focus should likely be for those seeking to build up a large pension pot. Why? Because that’s where compounding interest shines brightest.

The power of compounding interest

Both pension savings and investment accounts benefit from compounding interest. This means that any gains received will then contribute to further gains in the future, creating a wealth-building snowball effect in the long run. In other words, interest earned is based on deposits and any previously received interest.

For example, let’s say an investor has an extra £500 at the end of each month from their paycheque. They can either put the money into a savings account at a 2.5% annual interest rate or invest in an index fund that has historically generated annual returns of 8%.

The table below shows how much wealth can be built up in the long term when starting from scratch.

From the table above, it’s clear to see how, thanks to compounding, investing can generate significantly higher returns in the long run. And it emphasises the importance of starting early. As exciting as the prospect of having nearly £4m in the future might be, there are a few caveats to remember.

Unlike putting money into a saving account, investing carries significantly more risk. Just because a particular index fund has generated an average return of 8% in the past doesn’t guarantee it will continue to do so in the future. Furthermore, the stock market occasionally goes through periods of weighted volatility, such as a crash or correction. And these events can significantly derail the wealth-building process. Therefore, investors may end up with substantially less than expected in the future.

How much money should I save for retirement?

It can be tricky to determine the right amount of monthly pension savings an investor should put aside. As previously mentioned, a general rule of thumb is 10% to 15% of gross income. However, in practice, the right amount could be higher or lower than this range.

It ultimately depends on an individual’s personal circumstances. And some common factors that influence the savings requirement include:

• Time Horizon – How long until the individual intends to retire. Someone retiring in the next ten years will likely need to contribute significantly more than someone with another 30 years to go.
• Desired Lifestyle – Individuals seeking to live in luxury will need to save more than those who are content with living a more modest lifestyle.
• Existing Wealth – Those already with significant wealth may not need to save as much as those still in the process of building wealth.
• Risk Tolerance – Investors who aren’t comfortable taking on additional risk by deploying strategies like stock picking may need to contribute more due to the lower returns offered by low-risk asset classes like bonds.
• Passive Income Streams – Individuals with a stream of reliable passive income, such as rent received on leasing real estate, may not need to save as much compared to those whose sole income source is a salary.

By considering these factors, an investor can better gauge how much they need to put aside to meet their retirement goal. However, speaking to a qualified independent financial planner is generally recommended if further help is needed.

7 tips for successful retirement investing

A large portion of retirement investing advice involves using lots of formulas and savings calculators. However, while these can be handy in defining investment goals, there are some additional factors to consider which aren’t commonly discussed.

With that in mind, here are seven helpful tips to help achieve a successful retirement strategy.

1. Choose the right investment account

Investors can use a regular investment account to build their retirement nest egg. However, this may prove unwise when taxes are taken into consideration. Fortunately, there are alternative types of investment accounts specially designed for building a retirement fund.

What’s more, these are tax-efficient, resulting in more wealth lining the pockets of investors rather than the tax man. However, each has its drawbacks and limitations, which must be considered when deciding.

• Stocks and Shares ISA – This is a special type of tax-efficient investment account for British investors only. All capital gains and dividends from investments within a Stocks and Shares ISA are tax-free. However, investors are limited to depositing a maximum of £20,000 per year.
• Self-Invested Personal Pension (SIPP) Account – This is a special type of tax-deferred investment account for British investors only. Capital gains and dividends received from investments are protected from tax. Furthermore, any deposits made are tax-deductible, with refunds issued into the SIPP shortly after each deposit. However, investors cannot withdraw any money until reaching the age of 55 (57 from 2028). And when funds are taken out, only 25% of the portfolio can be withdrawn tax-free. The rest is taxed as regular income.
• Employer-Sponsored Retirement Account – This is a special investment account with certain tax benefits. However, withdrawals from this account are limited until investors reach a certain age. They are designed to be a retirement-saving instrument for pensions. The most common type of employer-sponsored retirement account in the United States is a 401k plan.

Alternative Retirement Accounts

Another honourable mention for British investors is the Lifetime ISA. This special type of account enables individuals to deposit up to £4,000 a year and receive a 25% bonus from the government on any deposits. In other words, individuals can receive up to £1,000 a year by depositing money into this account.

However, the funds can only be withdrawn under specific circumstances:

• To buy a property in the United Kingdom
• As a pension after the retirement age of 60
• If the individual is diagnosed with a terminal disease.

Withdrawing funds for any other purpose will result in the complete loss of every government bonus received as well as being charged a fee. In this scenario, the individual will receive less than what they have put into the account, destroying wealth.

2. Pick suitable investment types

There are plenty of asset classes and investment vehicles available for investors to choose from. And they need to identify which is the most suitable to achieve their investment objectives without exceeding their risk tolerance.

• Annuities – Financial products usually offered by life insurance companies that provide a fixed source of monthly pension income.
• Mutual Fund – Invest in a basket of financial securities and assets to grow shareholder capital either in line with a benchmark index or attempting to beat a benchmark index.
• Index Fund – Invest in low-cost funds that replicate the stock market’s average performance.
• Exchange Traded Fund (ETF) – Invest through a cost-effective investment vehicle to gain exposure to a wide range of financial assets.
• Target Date Fund – Invests in various financial assets, including stocks, bonds, and money market instruments, to balance risk and reward. The composition of the investment portfolio becomes more conservative over time as its investors grow older and eventually reach retirement.
• Stocks – Invest directly into publically traded companies. Setting up a dividend reinvestment plan (DRIP) to automatically repurchase shares whenever receiving dividends can be an effective way to accelerate compounding with stocks.
• Bonds – Invest directly into buying debt from companies or government institutions.
• Real Estate – Invest in property with a traditional mortgage or through various real-estate financial instruments such as a real estate investment trust (REIT).
• Cash & Equivalents – Deposit money into an interest-bearing savings account or invest in a money market fund to generate small returns at low risk.

3. Start early

Starting early is critical regardless of the investment strategy, account, or asset classes being used. Compounding is a snowball effect that exponentially accelerates the longer it can run. But beyond maximising wealth generation, it also provides other advantages.

• Instils a habit of consistently saving or investing capital.
• Longer time horizons provide more flexibility to take on risks in pursuing higher returns.
• Gain valuable investing experience.
• Have more time to recover from losses due to market volatility.

4. Work out current financial position

By calculating their current net worth, investors can get a better sense of where they stand in relation to their long-term retirement goals. This means working out what assets (savings, investments, real estate, valuable possessions) they currently have and subtracting them from existing liabilities (mortgage, rent, car lease, credit cards, student loans, medical expenses, monthly subscriptions).

With a net worth figure calculated, it’s far easier to see how far an investor is from reaching their objectives. And it can serve as a method of tracking progress while saving or investing for retirement.

5. Don’t forget about fees

While there are typically no fees for depositing money into a savings account, the same can’t be said for investing.

Depending on the type of account and investment vehicle being used, there are numerous costs to take into consideration that can eat into long-term returns.

Some common examples include:

• Annual Investment Account Fees
• Transaction Costs
• Investment Fund Expense Ratios

6. Remember to diversify

Keeping risk in check when building a retirement portfolio is paramount to success. Designing a suitable asset allocation strategy and diversifying across a broad range of securities within each asset class reduces portfolio risk. That means, should one investment fail to meet expectations, the others can mitigate the impact on the overall portfolio.

7. Seek professional help when needed

Many individuals postpone retirement planning simply due to a lack of knowledge on the subject. Yet this mindset can be a significant hindrance in the long run. And may even prevent an individual from achieving their retirement goal.

Plenty of resources are available online to gain a basic or even advanced investing education for free. And spending some time to learn can pay enormous dividends. However, for those who aren’t comfortable or don’t have the time to learn, speaking with an independent financial adviser can be a prudent investment decision.

The bottom line

Investing for retirement is a proven strategy to improve the odds of enjoying a comfortable retirement. Even if it’s contributing seemingly small quantities today is enough to build a substantial pension pot in the long run. And starting early only amplifies the potential results.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.