Why and how young adults should prioritise a pension

How you invest in your 20s can make a huge difference to your personal finances and long-term wealth. Katie Binns explains how to approach saving into a pension.

Where to begin with young adults’ finances? Pre-pandemic, many young adults struggled to save and buy a home. Post-pandemic, things may become even more difficult.

Rising costs

As costs rise faster and for longer than many of us expected, young adults, typically with lower salaries, may feel the impact of the cost-of-living crisis more than others.

Around 28% (3.58 million) of young adults now live at home, according to the Office for National Statistics (ONS). No prizes for guessing why! UK housing costs are at an all-time high: the average UK house price was £286,079 in April, and the average cost of rent for the first quarter of 2022 is £1,088, up 10.8% from the same time last year.

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Young adults are typically more affected by rises in transport costs, too. Not only that but graduates also have to pay 9% of everything they earn over £27,296 in student loan repayments. And inflation is predicted to hit 10% by the end of the year which will only squeeze young people’s incomes further.

For any young adult who is keen to still try to build wealth amid many competing priorities, we explain how to approach saving into a pension. How you invest in your 20s can make a significant difference to your personal finances and long-term wealth.

Double your pension investments

When you start saving into a pension, your employer will pay in at least 3% of your salary, and you will contribute a further 5% as part of the auto-enrolment scheme.

Some employers pay in more than this obligatory 3%. Some even match your payments up to a certain percentage too – meaning they’ll pay in more if you do. It’s a valuable benefit that can effectively double the amount that goes into your pension scheme so it’s worth checking to see if your employer is that generous.

On top of that you’ll receive tax relief - described as the ‘secret sauce’ of pensions by Becky O’Connor, head of savings and investing at interactive investor. If you’re a basic-rate taxpayer, a £100 contribution requires a personal contribution from you of £80, with £20 from tax relief – that’s like getting an immediate 25% boost to your contribution from the government. 

And it’s a significant extra in the context of rising taxation - the more you put into a pension, the less tax you pay.

How much could your pension grow?

Let’s make some modest assumptions. If you put £200 in a pension each month between the ages of 22 and 30 (£21,600), then didn’t put anything else in after that, you’d be left with about £117,848 in 35 years when you’re 65. This assumes 5% annual growth. 

If you could achieve annual growth of 7%, that money could grow to about £252,300.

(This includes tax relief and 3% employer contribution – so total contribution of £2,400 a year.)

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Myron Jobson, senior personal finance analyst at interactive investor, says: “Runaway inflation means that consumers face an uphill battle to keep up with day-to-day expenses from food, energy and petrol - let alone to edge closer towards achieving long-term financial goals. But it remains important to plan for tomorrow.

“If you can afford it, investing can help grow your wealth and hit major financial milestones over the long term. Even modest contributions can make all the difference in the long run.” 

The benefit of accepting more investment risk

How your pension works out will also depend on your investment choices. Young adults often don’t realise the benefits of accepting more investment risk by investing in a higher proportion of stocks and shares in exchange for the possibility of higher returns. Stocks and shares are higher risk than bonds or cash because they tend to fluctuate more in value over time. But they also tend to grow more over time, maximising your investment wealth.

Moira O'Neill, interactive investor's head of personal finance, says younger investors can afford to take on this risk. “Younger investors have the ‘superpower’ of harnessing time in the stock markets plus compound interest. Understanding the consequences of taking on additional risk and how this can affect your investment goals is very important to learn at a young age.”

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For example, take someone earning £20,000 and saving an extra £25 a month into their pension on top of the minimum automatic enrolment contributions, from the age of 23 to 68. If they invested cautiously, with less exposure to shares, achieving a 3% annual return, they could have an extra £28,000 by retirement at age 68, compared with someone investing the minimum amount. 

But if they increased their risk profile and sought a 5% annual return by investing higher amounts in shares, they could have an extra £132,000 at retirement – that’s a huge difference and could make a comfortable retirement that little bit more achievable.