Pensions: how much should you save?

Pensions can be depressing and confusing to think about. But you can increase your chances of achieving the retirement you want, and do away with some of the angst you feel, by simply working out how much you're likely to need, and how you'll get there. So how do you do it?

First, work out how much you'll need to live on. Don't worry about inflation for now. Simply take your cost of living today. Then adjust for the fact that you'll hopefully have paid your mortgage, and that your children (again, hopefully) will be past their most expensive years.

Then consider the lifestyle you want exotic holidays and fine dining, or something more modest? It's no more complicated than doing a monthly budget plan.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Say you think £30,000 (before tax) a year is enough. That's £2,157 a month after tax, assuming that by then pensioners have the same personal tax allowances as everyone else (they're currently a bit more generous).

What you have to do now is to calculate what size of savings pot will give you the annual equivalent of £30,000 a year (in today's prices) on retiring.

Building your savings pot

Just now a 65-year-old man with £100,000 can buy an income of just over £6,000 a year 6% of his fund. (If he wants inflation protection or security for his widow should he die, he'll get less.)

Future annuity rates will depend on things such as government bond yields and the path of life expectancies. But say they stay at 6%. If you want an income equivalent to £30,000 in today's money, you will need a pension pot of £500,000 (simply divide £30,000 by 0.06 to calculate this).

Because of inflation, the actual pot will need to be a lot bigger than this, but we'll get to that in a moment.

Saving with an individual savings account (Isa) is a bit different. You can buy an annuity with it if you want to, but that goes against the whole point of using an Isa in the first place.

Unlike annuities, with Isas you do have to worry about running out of money. There's a lot of debate about how much you can safely take out of a fund each year without burning through your cash too quickly (known as the withdrawal rate'), but 4% seems a commonly quoted number.

At this rate, if you turned your Isa into cash when you retired, your money would last about 25 years. Alternatively, you might be able to put together a portfolio of income investments paying 4%.

At 4%, if you want your Isa pot to generate £30,000 of income a year, you need a bigger pot than in the last example. But because the income you take out of an Isa is tax-free, you only need the equivalent of the after-tax amount of £30,000 (which is £25,884). At a 4% withdrawal rate this means you need a £647,100 pot (£25,884/0.04).

What return can I expect?

This is a really hot topic many pension-fund providers have been way too optimistic on the returns they expect to get on their investments. So be conservative. Don't expect to be bailed out by a bull market, and you stand less chance of being disappointed.

We are looking for £30,000 a year in today's prices. So the return we need to use has to account for inflation in other words, we need the real' rate of return.

Until recently, many pension providers assumed a real rate of around 4.8% (7% before inflation). That seems too high a more prudent real' assumption would be around 2%.

How much do I need to put away?

AF = (1 + rate of interest)^number of years invested 1/rate of interest.

You can do this easily on a scientific calculator or spreadsheet, or you can find annuity factor tables online or in print.

So take a 30-year-old who plans to retire at 65 so saves for 35 years and expects to earn a 2% real rate of return on their investments. That gives us an AF of 50: (1.02^35)-1 0.02.)

Now divide your total estimated pension pot by the AF to get the amount you have to save each year in order to get there. In this case, we estimated you'd need £500,000 to generate £30,000 a year in today's money: £500,000 divided by 50 equals around £10,000 a year, or roughly £833 a month.

Bear in mind that this £833 monthly payment is in today's money. You will have to increase it by inflation every year in order to build a pot of money that will buy the same amount as £30,000 does today when you retire.

Tax relief on pension contributions cuts that to £667 for a basic-rate taxpayer or £500 for a 40% taxpayer.

An Isa saver would need to save £1,078 a month (£647,100/50), more than the £960 a month that is currently allowed. But bear in mind that Isas carry their own offsetting benefits all withdrawals are tax-free and you are not restricted on how much you can take out.