You need to know the rules in order to break them successfully

How much should I save and when can I retire?

Personal pensions have a bad reputation compared to final-salary company pensions but if you have a responsible employer making healthy contributions, and you’re a higher-rate tax-payer, the level of saving required to achieve benefits equivalent to a final-salary pension scheme is not as painful as you might think.

Savings and Retirement

Stockmarket returns in the last 15 years have dented confidence in the money-purchase personal pension but over the time-horizon of a working life, using sober assumptions, there is every prospect of building up enough income for a comfortable retirement as the table below illustrates.

 

A comfortable Retirement

Most of us spend what we earn, so the idea that 60% of your earnings is sufficient to ensure a comfortable retirement – defined as one where you don’t have to make any cut-backs to your lifestyle – seems impossible.  The assumption in the table above is, firstly, that mortgage payments soak up 40% of your income and, secondly, that the mortgage is paid off by the time you retire.  While it is possible to ‘get by’ on less than 60%, increasingly uncomfortable sacrifices have to be made or other savings used to make up the shortfall.  Much below 50% and the lifestyle you have been used to will probably have to be significantly curtailed.  Many people in such circumstances will choose to work on, perhaps in a part-time job.

For many people, a ‘comfortable’ retirement also means retiring earlier than the state retirement age, now 68 years.  55 years is the minimum age at which a personal pension may be drawn but for most people this is unnecessarily early.  30 years doing ‘hobbies’ sounds like a prison sentence to me.  Most of the people I know that are retiring now are still fit and vital and are in their early sixties.  The often-quoted savings figure of 15% is too little for that purpose.  You should aim for a rate of 16.5% if you want to retire at that age.  This is also the rate at which your private pension is likely to match the benefits of a final-salary scheme.

Saving

The biggest pitfall of retirement planning is not saving enough.  The saving % in the table above is a lifetime ratio per person.  If, like me, you neglected saving in your twenties, or your partner’s working life has been interrupted by other commitments, it will mean you either have to save more, or rely on a windfall of some description to make good the shortfall.  Downsizing and family bereavement have been sources of extra cash for my generation but the boom in property prices behind such windfalls may not be available to the generations coming later.

I’m an accountant.  Like a doctor that smokes, I ignored my personal finances until my late thirties.  Why?  Partly it was that all my spare cash that could have been saved went on other things, like furnishings, cars and holidays; partly, it was because I was in a secure job with a final salary pension and assumed everything would be alright; partly, I found the whole financial investment industry confusing, particularly the way my fund valuations always seemed significantly less than the underlying stockmarket returns (fees, of course, was the explanation).  Also, my time horizon was never very long, so the amount of money I was likely to make never seemed large enough to be worth the effort required to understand what was going on.  All that changed when I started working for myself, but even then it was not until my mid forties that I really took a close and detailed look.  To my relief I discovered my savings were sufficient but it was more luck than judgement.  If that’s the experience of someone who finds finance interesting, heaven help the majority of people that find finance boring.

Other Considerations

Next to the amount you save, all other considerations are secondary.  Nevertheless, it’s wise not to overlook the following:

Fees:  the initial charge and annual management fee will certainly make a dent in the returns on your investment.  I once compared what it would cost me in fees, spreads, commissions etc if I self-invested my portfolio, turning over half my holdings every five years.  It turned out to be 0.88% so I can live with annual fees up to this amount.  The initial charge still hurts but, like annual fees, this can be negotiated down.

Investment Performance:  where to invest to get the best return?  Your guess is as good as mine.  Forming a view on that question would take more investigative effort than I have time for, so I go for trackers.  They have the lowest fees.  In the table above I’ve assumed 100% investment in equities will earn a real return of 4.2% per annum which is eaten away by fees, commission and charges to be a net 3.1% per annum.

Annuity rates:  as I write, annuities have gone about as low as they possibly can.  In the table above I’ve assumed an escalator annuity rate of 3.80%, equivalent to a flat rate annuity of 5.45%, for a joint life at age 60.  These are my own estimates of rates at which a prudent life assurance company should be able to make money in the future, even if lifespans keep going up.  An independent financial advisor will navigate you safely through the different options.

Inflation:  final-salary pensions tend to rise with inflation.  If you buy a flat-rate annuity your spending power is higher in the first years of retirement but gets progressively lower thereafter.  This is not unreasonable as it makes sense that we would spend less as we get into our old age but, personally, I wouldn’t want to take the chance of being impoverished in my eighties, when I’m at my most vulnerable.  In the table above I’ve used a 3% escalator rather than an index-linked annuity.  In other words, I’m happy to shoulder a bit of inflation risk.

State Pension:  the investor relying on auto-enrolment contributions will need to supplement their income with the state pension before they reach a comfortable level of income.  This means working into your late sixties.  It has come as a bit of a surprise to me that I might eventually receive a state pension.  I never expected it would be universally available by the time I retire.  Now, halfway through my career, the universal pension is still here but there’s got to be a fair chance that the closer I get to retirement, the further away – or the smaller in real terms – it will be.

Summary

‘Black Monday’ in October 1987 first made me take notice of the market as a young trainee accountant.  Then the FTSE 100 index was about 1,700.  It embarrasses me that I had money I could have invested in the years that followed when the index marched up the hill and down again, twice, without me paying attention.  It wasn’t until 2012 I realised that, even after financial meltdown, the stockmarket was still the best investment.  (Currently the index is above 6,000, which means the return – ignoring dividends – has been 5% p.a over 26 years).  There’s an old adage about time in the market being what really counts.  I wish I’d known that when I was 21 years old.

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