When should you start saving for retirement and how much should you put by? The conventional answers to these questions are as soon as possible and as much as you can afford. But the conventional answers may be wrong, according to new research by the Institute for Fiscal Studies (IFS).
It is certainly true that the laws of compound interest mean money invested at an early age will work harder to deliver you a decent retirement income. But saving for a pension doesn’t happen in a vacuum. Money you move into it isn’t available for anything else. And that is potentially problematic.
Debts take precedence
The IFS’s modelling argues that once you take into account all your financial circumstances – rather than thinking about pensions in isolation – saving early often doesn’t make economic sense. Indeed, it would be much more rational to do the lion’s share of your retirement saving later in life.
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The explanation for this is straightforward. In your 20s and 30s, it is likely your income will be lower than later, as your career progresses. It is also likely that your outgoings will be higher.
You may be repaying student debt or covering the cost of a mortgage. You may have children. You may still be accumulating the possessions it takes time to acquire – furniture, for example.
Later, by contrast, these pressures may ease. Hopefully, you are earning more. And as children leave home and debt is repaid, your disposable income should rise further.
Spreading pension income equally across these two periods is irrational, the IFS argues. To make pension contributions early in your working life may require sacrifices and compromises that outweigh the benefits of saving. Equally, when your financial position improves, you may well be able to comfortably afford much larger pension contributions.
On this basis, the IFS’s analysis suggests a typical graduate who has two children should do at least two-thirds of their pensions saving after the age of 45. There is, of course, no such thing as a typical graduate: everyone’s circumstances will vary. But for all those people beating themselves up for failing to maximise their pension saving as soon as they leave university – which is what pension experts have always told us to do – this analysis makes comforting reading.
Join occupational pension schemes
There are a couple of caveats to bear in mind. Firstly, as the IFS points out, if you have the option of joining a pension scheme at work, doing so will qualify you for pension contributions from your employer.
Since you don’t want to miss out on these, it makes sense to join the scheme and pay the minimum contribution required to get the employer’s top-up. Doing most of your pension saving later in life does not mean doing no saving at all earlier on.
The other key point to bear in mind is that leaving pension saving until later does carry a risk. If you fall ill or lose your job in your 50s, you may find yourself unable to make up for the saving you opted out of earlier on.
For this reason, where you do have the ability to make higher pension contributions earlier in your working life, it is a good idea to do so. You can never be sure how things will pan out.
Nevertheless, the IFS analysis stands as a general principle. Compound interest is a powerful concept that can supercharge the value of savings made early. But the standard advice to take advantage of this overlooks the realities of people’s lives.
The IFS makes one final point. Its analysis also has implications for the way the government intervenes in pensions policy. At present, the minimum pension contributions required under the auto-enrolment pension system are the same whatever your age. This is also the case when it comes to the tax relief you can claim on pension contributions and the amount that the tax system allows you to contribute each year.
Why not rethink those rules to reflect the way people actually save? Lower minimum contributions earlier on, for example, might help more people join pension schemes, even if you require them to pay more later. Similarly, higher pension allowances for older savers would help people catch up.
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