How does your pension grow and make you money?
It’s often assumed that earning interest is the only way in which a pension pot can increase in value. However, there are in fact multiple ways in which your pension can grow over time and these differ relative to the type of assets in your pension plan.
What assets are in your pension plan?
Like other investment types, pension plans are made up of a range of different asset classes. Typically, there are three main asset classes: company shares, bonds and cash but pension plans may also include others such as property, commodities (like gold) and currencies. Depending on the type of investment plan you have, the combination of assets may be weighted more towards one asset class than another. For example, 80% of your plan may be invested in company shares and the remaining 20% in bonds.
A plan which is made up of both shares and bonds has three ways in which it can increase in value. The shares may pay out a dividend, the bond may earn interest or both assets may appreciate in value over time. What’s more, if an investment with three such assets is held onto over the long term, it can also benefit from the effect of compounding both the dividends and the interest it earns.
The effect of compounding
Compounding provides a powerful way for your pension pot to grow, especially over the long-term, by earning interest on top of the money you’ve already saved. It can have a big impact on the overall value of your pension at the point you start to withdraw from it. It’s essentially a great way of making your money work harder, without you lifting a finger. Though compounding is perhaps most commonly associated with interest, it’s not the only part of an investment that can compound.
Interest is typically earned on assets such as bonds and cash and is paid out for the privilege of borrowing these assets. In order for interest to be compounded it is firstly reinvested back into your initial investment. Then when any further interest is made it is earned on both your initial investment plus any interest this has already earned.
For example, you contribute £100 to your pension pot. After 12 months, this earns 5% in interest, so after one year, you have £105. After 12 months your £105 earns another 5% in interest, this now brings the total to £110.25. Your initial £100 contribution has now grown by £10.25 after two years without you having added any more money to your pension pot.
A dividend is a portion of a company’s earnings which is paid out to its shareholders. Dividends are typically paid out according to how many shares you earn in a particular company, although not all companies pay dividends on their shares. In a similar way to interest, dividends build up over time and can also be reinvested into your investment plan.
Over time as dividends build and are reinvested, they can then be used to buy additional shares. Each additional share then pays out another dividend which is in turn reinvested and so on. Let’s take a look at an example.
You own 1,000 shares in a company through your pension plan, we’ll call this company, Max Dividends. Each share is worth £1, so your initial investment totals £1,000. Max Dividends issues £0.50 for each share you own in their company.
At the end of the year, the company pays out dividends to its shareholders according to how many shares they own. For you, this amounts to £500 (no. of shares multiplied by the price of a share)(1,000 x £0.50).
Now, let’s imagine that the share price of Max Dividends increases to £2 per share. With your dividend reinvestment, you’ve been able to buy an additional 250 shares in the company (new value of dividends earned divided by increased share price) (£500/2).
A third way your pension can grow is through asset appreciation. This is when the value of assets such as company shares, bonds and property increases over time, although the value of any asset can go down as well as up.
The appreciation in value is calculated by subtracting the original price the asset was bought for from its current market value. For example, if as part of your investment fund a share in a company was purchased for £10 and 12 months later is now valued at £20 the value of the share would have appreciated by £10.
Influencing factors that affect asset values
Each type of asset will have different factors which influence whether it appreciates in value. Below are a few common reasons that affect an asset’s value.
- Demand and supply
Generally, when more people are looking to buy an asset than to sell it the price will typically increase. For example, the price of a company share or an ounce of a precious metal typically increases as demand increases.
- Economic outlook
The ‘health’ of an economy may also impact asset value. When an economy is growing, investors may buy ‘riskier’ assets, those which typically have higher return potential such as company shares.
Conversely, if the economy is in a downturn, investors may sell shares and buy ‘safer’ assets such as bonds, which in turn may cause the value of these shares to drop.
Inflation refers to an increase in prices over a period of time. As prices increase the buying power of money goes down. The value of property, for instance, goes up as inflation increases, making any investments in property as part of your investment plan more expensive.
- Interest rates
When interest rates are low the value of assets typically goes up. One reason is that the cost of borrowing or buying an asset is lower. Bond prices, for example, fall when interest rates go down. The value of investing in property can also go up as mortgage rates increase.
How to maximise the value of your pension
There are various ways a pension can increase in value. Simply just leaving your funds invested in your pension, you will typically see it increase in value over the long-term. However, there are several ways you can help to maximise the value of your pension.
- Increase pension contributions
Paying in as much as you’re able to can help maximise the value of your pension pot at the time you come to withdraw from it and allow compounding returns more time to accumulate. Plus, when you contribute to your pension the government will usually top it up. Most UK taxpayers automatically receive a 25% tax top up, but higher rate and additional rate taxpayers can then claim further relief through Self-Assessment. For example, if you are a lower rate tax payer,for every £100 you contribute to your pension, the government will add another £25 in tax relief.
- Avoid withdrawing from your pension
Keeping more of your pension invested gives the assets it’s invested in more time to grow as well as the chance for your pension pot to benefit from compounding returns.
- Combine your pensions
Combining your pensions into one pot may help to reduce ongoing fees. If you have multiple pension pots with multiple pension providers each one will charge you a separate fee to manage your pension. At PensionBee we charge one simple annual fee, ranging from 0.50% to 0.95% depending on your plan.
- Check how your pension funds are invested
You may wish to look for a plan that offers higher returns to boost your investments earning potential. However, your appetite for risk may change as you move through life. A plan such as our Tailored Plan automatically adjusts how your pension pot’s invested, moving your money into typically safer investments like bonds and cash as you approach retirement.
You may wish to consider the type of pension plan you’re invested in and adjust the risk level of your fund. Additionally, you may want to check out our pension calculator to see if you’re on track with your savings goals for retirement.
As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.
Last edited: 20-10-2022