We all know we need to save for our retirement – the financial industry, for one, never stops telling us.
But how much do you need to save? Exactly what will you need to enjoy the retirement you hope for?
This is an incredibly important question that tends to stump people, because it’s so far off, or because it seems so unachievable. But one of the best ways to raise your chances of hitting a goal is to know what you’re aiming for in the first place.
It’s a tough question, no doubt about it. And the answer is different for everyone. But here I’ll talk you through some of the key points to consider, so that you can work out what you need for yourself.
How much money do you need to live on?
Trying to work out how much money you are going to need isn’t easy.
After all, there’s no realistic way to guess what the price of a pint, or the cost of electricity will be 30-40 years from now. (Although it’s probably fair to say that both will cost a lot more than they do today).
So a better way to start out is to consider what your cost of living is today. Then take into account that by the time you retire you will hopefully have paid off your mortgage (so living costs will be lower), and your children will probably have left home (although that doesn’t necessarily mean you won’t be forking out for them anymore). And you won’t be contributing to a pension any more!
Then, consider what sort of lifestyle you wish to lead. Are you happy to live modestly? Or do you want a life of fine dining and exotic holidays?
Lets say you think that £30,000 will be enough. That would give you £2,135 a month after tax, (assuming that pensioners at that time have the same personal tax allowances as everyone else).
So now you need to build up a savings pot that will give you the buying power of £30,000 today when you retire.
How big does my pension pot need to be?
This depends on how you want to generate an income.
If you are using a pension fund (or a self-invested personal pension), then you need to think about what annuity rates (the amount an insurance company will pay you for as long as you live) will be.
At the moment, a person with a £100,000 pension pot can buy an income of just over £5,8000 per year. Another way to look at this, is that you can lock in a 5.8% return on your fund.
However, what annuity rates will be when you retire is anyone’s guess. It will depend on things such as the interest rates on government bonds and how long you are expected to live.
But let’s say that they are 5.8%. If you want an income equivalent to £30,000 in today’s money then you will need a pension pot of £517,241. You get this figure by dividing £30,000 by 5.8% (£30,000/0.058 = £517,241).
Remember, this figure is in today’s money. Because of inflation, the actual pot will need to be a lot bigger than this.
You don’t necessarily have to use a pension
Saving with an Individual Savings Account (Isa) is a bit different. You can buy an annuity with it if you want to, but that rather goes against the whole point of having an Isa in the first place.
Annuities can be good because you don’t have to worry about running out of money. But you may have to pay tax on the income you get from them.
With Isas you do have to worry about running out of money. But all the income and capital that you take out of them is tax free.
Because you have to be careful with your money, you probably won’t be able to take as much money out in percentage terms as you would with an annuity.
There’s a lot of debate about how much you can safely take out of a fund each year (known as the “withdrawal rate”), but 4% seems a commonly quoted number. So if you turned your Isa into cash when you retired, your money would last about 25 years.
If you want £30,000 of income to live on, then you are going to need a bigger Isa pot. Remember though, because what you take out of an Isa is tax free, you will only need the equivalent of the after-tax amount of £25,620 (which is £30,000 after tax) to give you the same amount of money in your pocket as an equivalent annuity.
With a 4% withdrawal rate this is:
£25,620/0.04 = £640,500
Do bear in mind that because you run the risk of running out of money with an Isa, it might be a good idea to have an annuity as well to provide some of your retirement income.
How long do I need to save for?
The longer you can save, the more chance you have of meeting your financial goal. Regularly saving and reinvesting any interest and dividends you receive for a long time makes a massive difference to the amount of money you can build up. Think of it like rolling a snowball along the ground. The longer you roll it, the bigger the ball.
This is why starting saving as soon as you can is a good idea.
What return will I get on my savings?
This is a hot topic just now. Many pension fund providers have been way too optimistic on the returns they expect to get on their investments. With stock markets in the doldrums and many economies weak, lots of people are finding out that they have not been saving enough for their retirements.
Remember here, we are looking to achieve an income based on today’s prices. We are looking for an income equivalent to £30,000 today at some point in the future. So the return we must use is the real (or before inflation) rate of return.
What rate should you use? Well, up until recently lots of pension providers have assumed that their funds can grow at 7% (including inflation) per year. With current inflation of 2.6% (based on the Consumer Prices Index) that implies a real return of 4.4% (7%-2.6%).
That’s probably too high. If you put together a portfolio that is spread across lots of different assets – to reduce risk – then a nominal return (including inflation) of 4-5% is a more prudent assumption. This suggests a real rate of return of say 2%.
So how much am I going to have to save?
I’m going to introduce you to a fairly simple but very powerful bit of maths.
It’s called the annuity factor (AF). It helps you work out how much money you will have if you invest a regular fixed amount of money for a period of time and at fixed rate of interest.
AF = (1+rate of interest^number of years invested) -1 ÷ the rate of interest
Where ^ is to the power of.
This is quite easily calculated on a scientific calculator or in a spreadsheet. Alternatively, you can get hold of annuity factor tables in books or on the web.
Take a man aged 30 today. He has worked out that he will have to work until he is 70, and that investment returns will average 2% before inflation (‘real’) for the next 40 years.
The annuity factor is: (1.02^40)-1 ÷ 0.02 = 60.40
We estimated earlier that to get a pension equivalent to £30,000 in today’s money you need a pension pot of £517,241. Divide this number by the annuity factor – 60.4 – to get the amount you need to save each year.
£517,241 ÷ 60.4 = £8,563 per year or approximately £713 per month.
(Strictly speaking to get the monthly amount, the interest rate needs to be divided by 12 and the investment period multiplied by 12).
Now you know why pensions are a big problem
You’re probably thinking: £713 a month! And you’re right – it’s a lot of money. There’s no easy way around it – saving for a comfortable retirement is hard work. If you want to be realistic about it, you can’t rely on rampant growth in the investment markets to bail you out – you simply have to save hard.
It also gives some idea of why the cost of pensions is such a big problem for companies and governments.
If you haven’t done so already – it’s time to start saving.