Why Compounding Income (Not Investments) Is The Fastest Way To Early Retirement
You probably already know about the power of compound growth. You’ve read the articles on it and seen the 12-year-old TikTok finance gurus explaining it. You might even have heard it referred to as the “8th wonder of the world” in a quote (falsely) attributed to the likes of Albert Einstein and Warren Buffet.
And while it might be a topic that gets rehashed over and over again, there’s a good reason for that. And the reason is that compound growth really is an incredibly powerful force to grow wealth and achieve financial freedom.
But there’s something that all the other experts out there are missing.
That’s the idea that compounding doesn’t just apply to investments. It applies to income too. And in fact, the power of compounding income is like compound investment growth on four cans of Red Bull.
If you want to maximise your wealth, reach financial freedom and retire early, compounding your income is what you really need to be focusing on.
How compounding income works
The idea of compounding is simply the snowball effect. When growth is constant, a bigger starting point will give you a bigger return in pounds and pence.
When you start an investment with £100,000, a 7% return will add £7,000 to your portfolio. With a £1,000,000 investment, that same 7% return nets you an additional £70,000.
Same percentage return, but an extra zero.
It’s why we’re obsessed with getting our clients to start investing as early as possible. The more years you have to snowball your money, and the more you contribute in those early years, the bigger the pot you have in the later years.
When it comes to income, it’s exactly the same.
Over the course of a working life, you expect to increase your earning capacity year after year. For many people, peak earnings will come at the end of their career, in the years just prior to them winding down towards retirement.
The reason why this is so important to understand is because small differences early in a career can make a huge impact later on.
Looking at your pay going up by 2.5% or 3.5% in a given year might not seem like much of a big deal. On an income of £150,000 that’s just £125 a month. Barely even noticeable. The thing is, though, those small amounts compound to make a massive difference over 30 or 40 years.
Think of it like hitting a golf ball. If you take a full swing and hit it plumb in the centre, you’re going to hit it 200 yards and right down the middle.
But what if you miss the centre by a millimetre? If you’re putting (i.e. you’re close to the target), you might still make it. But if you’re a long way off and going for a full swing, that tiny difference at the start will mean you miss your target by a long way.
Got the concept? Keep reading because we’re going to get into some specific numbers to illustrate this point in a mini-case study at the end.
Why compounding income beats compounding growth
Look, compound growth is great. It’s important. But without income to allocate to investments, you’re never going to be able to put enough money towards those investments in the first place.
Income is the fuel that drives your financial future. You could lose all of your assets tomorrow, but if you have a high income and a solid strategy, you’ll be able to build them back up again.
The more you grow your income, the more your investments grow. The same is not true in reverse. Just because your assets are increasing through a solid investment strategy doesn’t mean your income is growing and allowing you to put more towards them.
In our experience, some people put far too much emphasis on saving an extra 0.15% in fees or earning an extra 0.43% in return and not enough on building their income in the same way.
Compound income through multiple income streams
“That’s great, but I can only get X% a year pay increase because I’m in the XYZ industry.”
Sure, sometimes this is the case. If you work in the public sector, like the civil service or if you’re a medical consultant, there are pay bands that aren’t too negotiable. Or maybe you’re working in a startup and sticking around on a sub-market salary in order to pick up stock options.
Regardless, it is still 100% possible to compound your income.
Multiple income streams are becoming more and more important. Job security in many industries is getting lower, even in the industries thought to be the most secure in the world.
For a decade, software engineers have been able to practically name their price in Silicon Valley, and yet in the last six months, we’ve seen massive layoffs all across tech.
It really doesn’t take much for a second or third income stream to add a percentage point or two to your main source of earnings. On an income of £150,000, you need just £3,000 a year (or £250 per month) to increase your income by 2%.
Here’s just a few examples of things you could do to earn that:
Consulting work for a couple of hours a month
Speaking engagements
Write and sell a book
Take on a role as a board member or non-executive director
Work some minimal additional hours in the private sector for public sector workers
Note we’re not talking about side hustles like Deliveroo or mowing lawns on the weekend here. Not only do these give you the ability to increase your earnings now and build that compound income, but they’re also likely to widen your network and build your authority in your industry.
That’s sure to help you increase your income even more in the future.
But what kind of difference can this really make? Let's look at a case study to show how incremental improvements to your income can make a massive difference down the line.
Mini Case Study: Frederick
Frederick is 32 years old and works as a Software Developer. He’s good and well-respected in his field. But he’s not ‘name your price’ levels of good.
Currently, he earns £110,000, and he’s about to go into his annual performance review. He knows the industry is more challenging right now, and he’s been forewarned not to expect a big pay bump.
But with inflation so high, he’s hoping he can scrape at least a 3.5% pay rise.
He’s going to be disappointed. His manager has been given an overall budget for pay increases which equates to his 1.2% of his direct reports existing salaries. It means that Frederick is going to be lucky to get 2%.
Now, let’s imagine that the outcome of this pay review follows the same trajectory every year for the rest of Frederick’s career. Say he wants to increase his income by 3.5%, and his employer only has the budget to increase it by 2%.
Sure, reality is going to be less linear than this, but it’s going to be really powerful to see the difference for illustrative purposes.
Let's look at the two outcomes.
Outcome One: 2% pay rise each year until retirement at age 60
So in this scenario, Frederick has taken what he’s been given each year, not pushed for additional responsibilities or promotions, not looked for additional income streams and basically just coasted along.
Salary age 60: £191,513
Outcome Two: 3.5% pay rise each year until retirement at age 60
In this scenario, Frederick makes a conscious effort to increase his income each year. He sets 3.5% as his minimum baseline and finds a way every year to increase his earnings by this amount.
Some years he moves jobs; some years, he takes on additional income streams and others, he pushes hard for promotion or extra pay increases at his current job. The important thing is it becomes a non-negotiable for him.
Salary age 60: £288,219
Not only is Frederick banking almost £100k more each year by the time he’s hit his desired retirement age, but he’s also earned an additional £1,113,042 over the course of his working life.
Put another way, Frederick could stop working at age 55 under scenario 2 and earn the same as he would if he worked until age 60 in scenario 1.
Next steps
This doesn’t necessarily need drastic action. We’re not talking about tripling your income every year. What it does need is a plan. And not just a plan on how to earn more but a plan that includes what to do with all the additional cash flow.
To really feel the benefit of earning more income, you need to use it the right way. That means making sure you have investments in place that can accept regular contributions.
It also means ensuring that every time you manage to level up your income, you level up your contributions as well. Once your living costs are met, this should mean that the percentage of your income that you invest goes up every year.
Yes, there will be some increases in costs with inflation (both actual inflation and ‘lifestyle’ inflation), but it’s vital that you don’t allow this to eat up all your additional funds.
At Roscut, we can help you work through these details. To arrange a no-cost, no-obligation discussion, book a time now.
