What is one of the most effective Birthday presents that you can give to a child? Toys, clothes, games consoles, sweets? The answer is only limited by your imagination and your budget.
As an alternative to the usual disposable gifts, you could offer a combination from the worlds of science, mathematics and economics, with a touch of psychology thrown in. Firstly, let’s consider the issue.
It is widely accepted that many people in the UK simply haven’t saved enough money (primarily in pensions) to maintain their desired standard of living for their retirement years. This problem impacts society and successive governments are perplexed by the scale of it.
Unfortunately, people can’t undo what’s already done because we don’t get a second chance to relive our lives. What can be affected though, is the outcomes for those children or grandchildren who are just starting out.
Consider the science: Einstein was quoted as saying that compounding is the eighth wonder of the world. Compounding is best observed over long periods of time, so let’s consider 57 years in our example.
From an economic perspective, there are very few free handouts in life, especially from the government or HM Revenue & Customs, but they do exist and pension tax relief is one of them. From birth, every child is entitled to save into a pension. Payments into the pension plan can be made by family or friends. The child won’t have any earned income (probably) and the maximum that can be saved each year is £3,600 gross. Because of 20% tax relief, only £2,880 needs to be invested (the extra £720 is added by HMRC).
Many newborns will likely have two parents, four grandparents and some uncles and aunties. That means several people can share the cost of the annual investment if needs be. If we assume there are eight family members contributing, the individual monthly cost is just £30.
Now for the mathematics. Nobody knows what the future holds, so assumptions need to be made. Here they are: the regular pension contributions continue at their current rate for 57 years. Future investment growth on the pension fund is assumed to be 5% and inflation is deemed to be 2.5% (the FTSE All Share Index generated nominal annual returns of 7% since 1917).
Under the current 2017 rules (they will change) a personal pension can be accessed at age 57 or older by a child born today. So, in this example from birth to age 57, how much value could be accumulated during the period? Have a guess?
The future value is £273,000 in today’s money after factoring in inflation. As the popular saying goes “Time is money”. An alternative scenario is to make contributions from birth until age 18 and then stop and letting the pension fund to grow until age 57. This creates a fund in today’s terms of £170,000 for contributions (also in today’s terms) of £42,000.
What about the psychology element? This has several aspects and each situation will differ. Many people do consider that their birthday gifts will soon be outgrown, outdated, broken or unloved before too long. The elation is fleeting at best. Also, saving a little bit over a long time is easy to adjust to and is soon accepted. Thirdly, inflation increases are a matter of fact and we can deal with it. The child, who becomes the adult can’t simply in a whim ‘smash’ the piggy-bank pension so in effect, they are protected from themselves. Doing good feels good.
At Capital, we love to bridge the gap between art and science, fact and emotion.
Future investment returns are not guaranteed and you may get back less than what was invested. Future returns will differ from the assumptions used. Government legislation may change. Future tax circumstances may be different. The figures used are a guide and not guaranteed.