Why young professionals need to plan early…

For the last 2 years, returns on cash have been higher than they have been for nearly 20 years in the UK.[2] A common conversation I have with clients stems from the question: “Why invest in the stock market when I can get a guaranteed return on cash?”.

Cash is a vital part of any financial plan, but it shouldn’t be the financial plan. What I mean by this is everyone should have an emergency fund that is held in cash or cash equivalent products. However, particularly for those in the accumulation phase of their lives, it is not an optimal long-term strategy for building wealth. Furthermore, great tax planning can far outweigh returns on cash, even in struggling investment markets. Take the below chart for example. This shows a 20-year comparison of the returns on cash, bonds and a global investment fund tracking the performance of the world’s largest companies. The global equity fund has significantly outperformed the other two asset classes.

Source: FE Analytics – Accessed[3] Cash savings vs investing | Saltus

The above chart shows the journey of £1 million invested into global stocks in red (MSCI World), bonds in blue (UK government bonds), and cash in green (using the Bank of England base rate + 1% as a proxy for cash). The differences after 20 years are startling:

With smart planning and an investment strategy suited to the investor, a solid financial plan should outperform a cash-based savings strategy over the longer term.

Cash savings vs financial plan

Let’s see the difference a great financial plan can make to ‘Jimmy’; a 30-year-old working professional, with the following assumptions:

• Salary in 2024 of £130,000 gross at age 30
• 5% pension contributions through auto-enrolment
• Annual return on cash 3% sustained for 30 years (although you may see cash rates of 5% and sometimes even higher, this isn’t a true reflection of the return on cash over a longer time period – think back to just a few years ago where we were lucky to get 0.1% on our savings!)
• Annual family expenditure of £40,000
• Retirement at age 60 (30 years’ time)

Scenario 1

Jimmy receives no financial or investment advice in his lifetime. All of his surplus income is saved into his fixed rate savings account at 3%. As an additional rate taxpayer, any interest is taxable. [3]

Scenario 2

Jimmy recognises the need to make his funds work harder for him in order to reach his retirement plans – He wants to retire at age 60 with income of £40,000 net in today’s terms. He is working with a financial planner utilising firstly his pension annual allowance, as well as the use of an annual ISA allowance to maximise the end result.[4] Making pension contributions has reduced his income tax liability by both regaining his personal allowance and extending his marginal income tax bands.[5] For this, we have used an annualised growth rate of 4.75% which has been determined by Jimmy’s risk assessment and wider circumstances to determine his risk profile (A moderately adventurous growth figure for a 30 year period, net of all fees).

From the example above, we can see that there are two very different end results, with an almost 100% increase in scenario 2 at age 60 vs scenario 1 at the same age. This stems from two key principles:

1. Historically, investments have outperformed cash over the longer-term. [6]
2. Tax planning which maximises the amount that is working towards retirement goals as opposed to being paid to HMRC as a tax on savings. We have fully regained Jimmy’s £12,570 personal allowance where he pays 0% income tax, and his £500 personal savings allowance as a higher rate taxpayer.

It is clear that the two scenarios have very different outcomes for Jimmy and his family. Although scenario 1 is not a bad outcome, his retirement could be so different when compared to scenario 2 which involves making tax efficient contributions to various tax wrappers during his lifetime in order to prepare for retirement. Capital is at risk in scenario 2 in order to generate the difference and though there are no guarantees of outcomes, there are countless studies that show an outperformance of investments vs cash over longer time periods.

Summary

In comparing the two scenarios, Jimmy’s working life (age 30 to 60) shows a substantial tax and National Insurance saving of £494,668 alongside a financial plan tailored to his retirement goals. This approach has resulted in a significantly improved overall outcome upon reaching his retirement age – Hence, my first point, compound interest coupled with a sound financial plan, might rightfully be deemed the true 8th wonder of the world.

These compounded effects stem from two fundamental principles: investments consistently outperforming cash over extended periods and strategic tax planning aimed at minimizing lifetime tax obligations for Jimmy.

In the first section of this article, we delved into the essence of what compound interest is. For young professionals, having a longer time horizon gives them a greater opportunity to take advantage of the benefits of compounding interest. Planning early increases the likelihood of achieving objectives such as retiring earlier, buying the dream holiday home, going on a particular holiday each year.  The later they start the more difficult it becomes to take advantage of the tax benefits and longer-term benefits of compounding through financial planning – Not impossible, but definitely more difficult!