There are lots of scare stories about savings for retirement. We’re not doing enough. We’re going to be poor in our old age.
We just can’t afford to save what we need. This is all rubbish. A little discipline is all most people need to plan for a comfortable retirement.
First, you need to understand what the State will provide. The whole system is changing. From 2010, you will need only 30 years of National Insurance contributions to qualify for a full State pension.
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Retirement is going to get later and later
From 2012, the State Second Pension (S2P) becomes a flat-rate top-up to the State pension and stops being earnings-related. And the State pension is then linked to earnings, not prices, so will increase at a faster rate. From 2024 the state pension age starts to rise until by 2046 it is 68 instead of 65.
What does all this mean? The government’s projections are that for someone retiring at 68 in 2050, the combined State pension will be worth £145 per week in terms of 2007-08 earnings.
Let’s take that £145 per week as a starting point. A normal financial planning target is to aim for a retirement income of two-thirds of pre-retirement earnings. Lots of surveys have shown this is realistic if you want a comfortable retirement lifestyle.
£145 per week is two-thirds of £12,000 a year (I’m rounding figures to keep it simple). That means the State pension will provide you with about two-thirds of your first £12,000 a year of pre-retirement income. It’s up to you to save enough to produce two-thirds of the rest of your income. If you’ve only recently started work you can take the £145 per week figure for your state pension entitlement as a pretty close estimate for now.
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New retirement saving scheme
There’s more change ahead. From 2012, Personal Accounts start up. Anyone in employment and not already in a scheme at least as good as Personal Accounts will be auto-enrolled and will contribute 4% of their earnings; the employer and government add another 4%, calculated on earnings between about £5,000 and £33,000.
Most people earning under £30,000, starting work after 2012 and contributing throughout 40 years of working life should accumulate enough in a Personal Account to get close to the two-thirds retirement income target.
You will have the right to opt out of Personal Accounts but given that your 4% contribution is being matched by employer and government, this will be equivalent to throwing a lot of money away.
There is one wrinkle, in that the current means-testing system means that if you only save a small amount by the time you retire, you lose almost as much in benefits as you gain from your savings. But further reforms of means-testing are inevitable so it would not be sensible to use this unintended warp in the current system as an excuse for not saving.
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The missing years
There are lots of people in work who haven’t saved enough or indeed anything towards their retirement so far. But it may not be so bad. People earning under £33,000 will benefit to the full from the new Personal Accounts system if they stay enrolled in a Personal Account from 2012 until they retire. Moreover, so long as they accumulate 30 years of NI contributions they’ll qualify for the full State pension.
They will still need to save something to make up for the missing years, but how much it’s hard to say. You used to be able to get a personal pension forecast from the Department of Work & Pensions taking into account your own actual contributions, but the DWP has stopped providing forecasts as it rebuilds its systems to take into account the recent reforms.
The service won’t start up again until sometime next year, but when it does, get your own personal forecast and then work out how much you need to top up your State entitlements.
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Crunch the numbers
Now comes the tricky bit. How much do you need to save to accumulate £1,000 a year of retirement income? A crucial factor here is the rate of return you project. I am going to use 5% a year, which sounds low, but I mean 5% a year on top of inflation, because this is the long-term historical average return from investing in shares. And it means the figure you get from the projection is in terms of today’s purchasing power.
I’m also going to assume that the capital you accumulate earns a return of a bit less when you start drawing income from it, namely 4% a year. If you were to use today’s annuity rates, you would get a higher income but since nobody has the faintest idea what annuity rates will be in 20 or 30 years’ time, this is a lousy way to plan. The 4% return rate is based on heavyweight American studies that show that a higher withdrawal rate means you risk running out of money before you die. A 4% return means you need £25,000 of capital to generate £1,000 income.
OK, punch these numbers into the compound interest calculator and you get the following results.
Monthly saving needed to fund £1,000 a year of retirement income
| Years to retirement | Monthly saving needed |
| 10 | £160 |
| 20 | £60 |
| 30 | £30 |
| 40 | £17 |
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Here’s how it might work for a 22-year old
So let’s take Joe Soap, who’s just started work at 22 and is currently earning £27,000 a year. Knock £12,000 off that for what’s covered by the state pension, leaving £15,000. That means he needs to fund two-thirds of £15,000 or £10,000 in retirement income. That translates into a capital need of £250,000. He has over 40 years to go to retirement so he needs to save £17 times 10 or £170 per month.
When Personal Accounts start, Joe will pay in about £75 per month, with the same going in from his employer.
So the minimum Joe should be saving between now and 2012 is £150 per month and preferably £170. Now maybe Joe won’t find it easy to save that much. But why should it be easy? The truth is it’s always hard to save money. Joe just has to accept that either he saves that much now, or he has to save a lot more later, or he will be poor in his old age.
And Joe must also increase the amount he saves as his earnings increase- which will happen automatically with Personal Account contributions.
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Where to save
Personal Accounts will be a type of pension scheme, which has both advantages and disadvantages. You get tax relief on contributions and can take a quarter of your fund as tax-free cash when you retire. The drawbacks are that all your pension income will be taxable, that you’ve no access to 75% of the capital in the fund and that you can’t leave the capital to your family.
Some experts reckon the tax benefits of the pension plan are worth about 8% to a basic rate taxpayer. I reckon it’s less, about 6.25%. Either way, in my view the benefit is too low to make it worth tying up your own money voluntarily in this way. Instead, therefore, I suggest you save in an Individual Savings Account (ISA). You can set up a self-select ISA with a fund supermarket and link your contributions to Fidelity’s MoneyBuilder UK Index fund. This simply tracks the UK stock market and has costs of a tiny 0.3% a year.
Of course, if your employer matches any contributions you personally make to a pension plan, it’s worth taking advantage of this. But my figures suggest that for basic rate taxpayers, any additional voluntary savings should go into an ISA, where you control the cash, draw as much as you want and can leave the capital to your family when you die.
Savings for retirement isn’t an option, it’s a necessity. Get to grips with it, sign up for a savings plan and get on target for a comfortable retirement.
Important risk warning - please read
The value of your investment and the income from it can go down as well as up and you may not get back a significant proportion of your investment. Past performance is not an indication of future performance. If you are in any doubt as to the suitability of an investment, you should seek independent financial advice.
