The New State Pension works out at £730.60 per month or a little over £8,767 per year. In order to make your own independent income worth about the same each month, which you could draw on alongside the State pension when you retire, I reckon you need to accumulate about £225,000.
Harvesting the return from shares
I’ve chosen that amount of money as an example because the FTSE 100 share index of the UK’s largest public limited companies is currently yielding more than 4% a year in dividends. So, with £225k, you could put it in a FTSE 100 tracker fund today and collect the dividend income to supplement the State Pension. If the tracker yielded 4%, you’d have a second income worth £9,000, which is just over the state provision.
If you start putting away £2 every day, you’ll be saving almost £61 each month and you can start compounding your money. But putting it in a cash savings account will stop it from working hard enough for you, so I wouldn’t do that. Interest rates on cash savings accounts are pitifully low right now and you’ll need your money to compound at the highest rate of return you can get.
Historically, there have been higher annualised returns available from investing in the stock market. For example, Nerdwallet, the US-focused website, reckons the average annualised return from the stock market over the past 100 years has been 10%. So, potentially, you don’t even need to pursue a complicated investment strategy to reach your goal of accumulating £225,000.
Tracking the market, compounding the returns
I reckon a decent plan would be to pay your £61 each month into an index tracker fund, perhaps one that follows the FTSE 250 index or America’s S&P 500. But there are many trackers to choose between, each covering a different area of the market or a particular geographical focus. You can hold your tracker within a tax-efficient Stocks and Shares ISA or perhaps a Self-Invested Personal Pension (SIPP). Make sure you select the accumulation version of the tracker fund, which will automatically reinvest all your dividends for you along the way. You can switch to the income version of a tracker fund when you retire and draw on the dividends to supplement your State Pension.
But how long would it take to save £225k if you are putting away £61 each month? Let’s be a little more conservative than Nerdwallet and assume you manage to compound at an annual return of, say, 8.5%. According to the online calculator I used, it would take about 39.5 years. That’s not such bad news if you are just starting out in your career because for just £2 a day, you’ll be able to provide for comfortable finances in retirement.
You can speed up the compounding process by investing more each month or by earning a higher annualised return. And one well-trodden path for beating indices is to invest in carefully chosen, good-quality individual shares.
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Kevin Godbold has no position in any share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.