What is compound interest?

Whether you’re saving in a bank account or a pension, you could benefit from compound interest. 

That can boost your returns, especially if you can leave your money untouched for as long as possible.

Find out what compound interest is, how it works, and why it could be valuable for your pension.

Growth on your savings’ previous growth

Compounding’s when you generate growth on growth you’ve already received.

Compound interest’s the name for this effect specifically when it applies to interest.

For example, when you put money in a savings account, the bank will pay you interest on the original amount of money you put in after a set period, like 12 months.

The key is that, when you next receive interest, it’ll be added on top of the interest you received last time.

That can grow your savings faster over time.

For example, imagine that you held £1,000 in a savings account that pays 5% interest annually.

After one year, you receive 5% on your £1,000 - that’s £50. That sees it grow to £1,050.

Then, in year two, you get 5% on £1,050, a payment of £53. Now, you have £1,103.

Without adding anything else to your pot, the amount of interest you receive has increased. That process continually adds up over time - that’s compounding.

This effect gets stronger the longer you leave your savings untouched, as shown by the graph below.

How can compound interest benefit your pension?

Your pension can also benefit from compound interest, depending on what it invests in.

Pensions are usually invested in a range of different assets. It’ll vary based on the specific plan you’re in, but that might include stocks and shares (also known as ‘equities’), as well as cash that receives interest. 

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Likewise, it might also include bonds. These are loans made to companies or governments which then pay back an agreed interest rate, known as the ‘coupon’.

If you reinvest the coupon into more bonds, you’ll achieve a similar compounding effect to cash. 

Note that bonds are investments, and can fall in price. Or, if a government or company runs out of money and becomes unable to pay the interest, you could lose your investment.

If your pension holds cash or bonds, the interest received from these can also compound.

And, you usually can’t access your pension until later life (55 in 2026/27, rising to 57 from 2028). So, you’ll usually leave your savings untouched for longer, possibly even decades.

That period gives more time for your savings to compound and grow under their own steam. It’s also why making extra contributions can be even more powerful, boosting your savings ahead of retirement.

Make the most of your pension with PensionBee

With PensionBee, combine old pots into one easy-to-manage online plan. Then, view and contribute to your pot online via the website or app.

You can choose a pension plan that suits you and your risk tolerance. Or, stick with the default options - that’s our Global Leaders Plan for under 50s, and the 4Plus Plan for customers age 50 and over.

When you come to retire, you could start taking your cash flexibly via pension drawdown (from 55, rising to 57 from 2028). 

That involves leaving some of your pot invested. So, if it’s invested in cash or bonds, you could keep benefiting from compound interest, too.

Risk warning

As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.