It’s said that Albert Einstein dubbed ‘compounding’ as the eighth wonder of the world. While it may be a term you’re not overly familiar with, compounding has the potential to significantly affect your wealth, for better and for worse.
No doubt this is why Einstein is also reported to have said “he who understands [compounding] earns money, and he who doesn’t pays it”. This is why the importance of understanding how it works and the opportunities and threats it presents to your money cannot be overstated.
As part of Pension Awareness Week, we’re going to break down the effects of compounding, and why it could make the difference between you enjoying the lifestyle you want in retirement, or not.
Before we do, we need to look at pensions in more detail to understand how they work.
What is a pension and how do they grow in value?
While there are different types of pensions that work differently, nowadays the majority are set up as a Defined Contribution policy, which is also known as a ‘money purchase scheme’. With this type of pension, the money you (or your employer) contribute into it is invested into various assets, which may include:
shares
cash
Government bonds
commercial property.
The value of your pension, and the income it is able to generate, is based on the amount you contribute and the performance of the investments over time. However, the final value could also be given a significant boost by compound growth, which we will look at next.
How could compounding boost growth potential?
When you invest your money, you’re exposing it to growth potential. This could be accelerated with compounding, as any growth your money enjoys is then exposed to further growth potential in the future.
To demonstrate this, you might want to consider the following example. If you use a compound growth calculator, you will see that if you invested £100,000 and achieve an average growth of 3% every year, you could have around £103,000 at the end of the first year.
If you leave it invested, the growth in the following year will be based on £103,000, meaning it could then grow to £106,175 at the end of year two. By comparison, if you had received 3% simple interest, you would have received £3,000 every year, meaning you would have £106,000 at the end of year two, a drop of £175.00.
While this may not sound like a lot, when compounding works over time it’s effects can be significant. For example, after 10 years your initial £100,000 investment could grow to £134,935 with compound growth.
This is nearly £5,000 more than simple interest, which would provide £130,000 after a decade. After 20 years your £100,000 investment could be worth more than £182,000 through compound growth, compared to £160,000 with simple interest.
This means you would have an additional £22,000 for simply opting for compound growth over simple interest.
Is the potential for compound growth greater the longer you leave it?
As you can see from the above example, the longer you leave your investment exposed to compound growth the greater the growth potential. If you’re considering investing in a Stocks and Shares ISA, a pension or other stock market investment, the sooner you start the better.
This might be particularly true if you want to make monthly contributions, something you’re more likely to do with a pension. According to the same compound calculator, for example, if you invested £250 a month and had an average return of 5% a year, after 20 years the investment would be worth £102,761, thanks to the power of compounding.
If you made these contributions into a simple interest account, you would have just £89,877.00 – a drop of more than £12,880.
Please remember that this is only for illustrative purposes and does not consider the effects of inflation. You should also bear in mind that investing carries risks, and you may receive back less than you originally invested.
Can compounding be a threat as well as an opportunity?
Unfortunately, the answer is yes. While investing shows the positive impact of compound growth, there is also a major downside to it as well. This is when compounding comes into effect with debt.
In the same way compounding provides potential growth on growth already made, with debt it means interest is charged on any interest amassed. As a result, the amount of money you owe could spiral out of control in a very short space of time.
With a credit card, for example, any amount owing will have interest charged on it, and if you are unable to pay the full amount off, interest is charged on the outstanding balance. The following month, interest is again charged on the amount you owe, which also includes the interest accrued the month before.
This is why it’s best to settle the outstanding amount on your credit card at the end of the month if you can.
How can AFH Wealth Management help?
As you can see, compounding could make a significant difference to your overall long-term wealth, which is why contributing to your pension as soon as possible is typically a wise move. If you would like to discuss your pension, or are thinking of starting one, and would like to know more about compound growth, please call us on 01527 577775.
Alternatively, contact us to speak to one of our advisers, as we’d be happy to help.
10 September 2026