Why it pays to save as early as possible

The concept of building up a nest egg is as old as, well, eggs themselves: put aside money for that rainy day. The same applies to pensions: when you start to earn, join the pension scheme, save as much as you can, as soon as you can. 

Millennials and Generation Z have been better-equipped to understand the need to start saving early: financial education is now being taught in most UK schools, and auto-enrolment, brought into force in October 2012, means adults earning above £10,000 will be enrolled into a workplace pension scheme. 

For a good proportion of Generation X, this has been a hard lesson to learn, however. True, the majority will have benefited from saving into workplace pensions, whether they were lucky enough to be in an old defined benefit (DB) scheme or a more modern defined contribution (DC) scheme.

But many people in this age group, between 40 and 50, will have missed out on accumulating altogether.

It could be they were not the main breadwinner in the family, but have only just entered the workplace later on in life. It could be because their employers did not offer a workplace pension when they started out, or for myriad other reasons, they simply did not consider putting money into a formal pension arrangement.

Keep in mind that if you leave pension funding until you are in your mid-40s, you are giving yourself just 20 years to try and fund a 25-year retirement. Alistair Wilson

For this cohort of people, who may expect to retire in their 60s, the reality is they could face years of financial difficulty before the state pension kicks in - if there even is a state pension to rely on, given the government's propensity to keep pushing the state retirement date further out. 

"Those who don't start pension saving until their mid-40s will face a formidable challenge if they want to be able to retire at a time of their choosing with a decent standard of living," says Sir Steve Webb, director of policy at Royal London.

The power of compounding

One of the reasons it is great to start saving as early on as possible is the power of compound interest, or compounding. 

This means even if you are on a low salary in your 20s, can only set aside £370 a month into a pension, and you only have an expectation of 2.5 per cent annual growth on your savings, over time this will ratchet up towards a tidy sum.

Mr Webb explains: "If people start saving early enough, they have a realistic prospect of a decent retirement, at an acceptable retirement age. 

"Lowering the starting age for auto-enrolment from 22 to 18 will help greatly in this regard."

However, as the below figure from Royal London shows, leaving it later in life means you will have to save much higher amounts a month - up to 39 per cent of a monthly salary - in order to achieve the same goal.

Note: Assuming a starting income of £28,000, growing at 2.5 per cent a year, targeting retirement at age 65.

Mr Webb comments: "The upside of all this, is that the figures are the total contribution, gross of tax relief, and including an employer contribution.

"If you have a good employer who will match your contributions, then a 16 per cent target implies you contribute 8 per cent gross, and this in turn is 6.4 per cent net of basic rate tax relief. 

"That's not easy, but a lot more plausible than asking someone to pay 16 per cent on their own."

However, as Mr Webb adds: "Of course, the downside of these numbers is that if you leave it a decade you need half as much again, and if you leave it two decades, you would need to save at twice the rate of a 20-something."

But even if it is left til later in life, Alistair McQueen, head of savings and retirement at Aviva, has this advice: "It is never too late to save, and the relatively shorter timeframe to eventual retirement will help focus the mind."

Tax relief

Mr Webb's point about tax relief is an important one to consider. Pension contributions are tax-exempt on the way in, at 20 per cent for basic-rate tax payers and 40 per cent for higher-rate taxpayers. 

By putting aside money into a pension early on in life, individuals will benefit from years of tax-efficient investing, on top of employer contributions, if individuals are saving through a workplace pension.

Andrew Pennie, head of pathways for Intelligent Pensions, explains: "For higher-rate taxpayers, the tax incentive is hugely attractive - £100 invested in the pension would only cost the individual £60."

Tom Selby, senior analyst for AJ Bell, says there is an argument that one should make the most of the pension tax allowances "while they are still there".

He warns: "Although it is impossible to second-guess what any government is going to do when it comes to pensions tax relief, the trend in reecnt history has been to progressively hack back savings incentives at the top end.

"Given the chancellor has a black hole to fill in the NHS budget, it is inevitable that speculation about the future of higher-rate pension tax relief will return ahead of this year's Budget."

But even if someone aged 50 has missed out on nearly 30 years' worth of tax-efficient pensions saving, they can still benefit hugely from the tax advantages offered by pensions - while the government still offers them, of course.

It is inevitable that speculation about the future of higher-rate pension tax relief will return ahead of this year's Budget. Tom Selby

This is a point stressed by Vince Smith-Hughes, director of specialist business support for Prudential, who adds: "If you think about people who are making contributions in later life, you could be talking about people who are higher-rate taxpayers.

"Only one in seven people who are higher-rate taxpayers in employment go on to become higher-rate taxpayers in retirement, so they will have the benefits of the higher-rate tax relief when accumulating, and lower tax out on the pension pot when they are decumulating."

So is it too late?

Given the lost years of tax-efficient pension saving, employer contributions and compound interest, it could be easy to say it's too late for people to start saving if they are in their 50s, especially given the higher premium in terms of monthly contribution as outlined by the Royal London figures.

But in reality, it is never too late, says Alistair Wilson, head of retail platform strategy for Zurich UK. He comments: "Yes, the best time to start a pension was years ago. But the second best time is now."

Those who hit mid-life and have a mini-crisis (possibly buying a 1970s MG, getting hair restoring treatment and starting to think about a pension) should not simply resign themselves to an impoverished pensionhood.

There are things they can do to start funding their retirement, not least putting as much as possible into a pension, workplace or otherwise, and working out what would be the optimal retirement date for the individual.

Making the most of workplace pensions, and the employer contribution, is always a good place to start for those who fear they may have missed out earlier in life.

Says Mr Wilson: "The most activity we see in terms of money going into pensions is in the last 10 years before retirement, which is good, but people do wish they had started earlier."

While it is not impossible to build up a nest egg, the challenge of having left it later on in life is bigger and will require more sacrifice and willpower to surmount it.

"Keep in mind that if you leave pension funding until you are in your mid-40s, you are giving yourself just 20 years to try and fund a 25-year retirement.

"That's a much bigger challenge to do than it would have been if you had started in your 20s."

simoney.kyriakou@ft.com