What is compounding?

Over time, continuous investments can grow to a sizeable sum thanks to the benefits of compounding.

In simple terms, compounding means you earn interest on the interest that’s already built up on your savings. So even if you don’t add any more, it’ll still continue to grow. In a nutshell, it works by accumulating over time and can turn a small pot into a significant amount and the longer you remain invested, the bigger benefits you are likely to receive.

As an example, an initial principal of say £100 with a 10% annual return per year would be worth £110 after the first year, £121 the second year, £133.10 the third year, £146.41 the fourth year, and so on. This is, of course, a hypothetical situation and for simplicity assumes a steady 10% return per year, which is not a likely scenario for any investor.

Compounding and your retirement savings 

Some retirement savings accounts, such as your workplace pension or a self-invested personal pension (SIPP), benefit from tax relief on your contributions. This means there’s no income tax on the money you invest or on the growth of that money while it’s in that account. You can reinvest any gains and get the potential benefits of compounding. 

There are no limits to the amount of contributions that you can make across all your pension arrangements, but HMRC does restrict the level of contributions that can enjoy the full tax advantages. This restriction is known as the annual allowance for which the standardis £40,000. You can find out more about annual allowances here.

Invest early and often

The snowball effect of compounding makes early investing, particularly in a retirement account due to the tax benefits, that much more enticing since the earlier you start investing, the more compounded returns you can hope to make. 

Additionally, the more you contribute to your retirement plan, the better. At Fidelity, we suggest saving at least 13% before tax each year for retirement, this includes any contributions your employer makes. Remember, early withdrawals means that you will lose the power of compounding and you’ll potentially have less savings accumulated for your retirement. Read more of our retirement rules of thumb.

Next steps to consider

Discover the power of small amounts to see how small changes to your pension contributions can make a big difference over time.

Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Tax treatment depends on individual circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.