How to Make Your Pension Work For You #2

In our previous article, we looked at different types of pension, and how they work. In this piece, we explore what you need to do to live the life you want.

There are four key questions for pensions:

1. What retirement lifestyle do I want?

2. How much income do I need to fund it?

3. To generate that income, how large should my pension pot be?

4. To achieve that pension pot, how much should I contribute today?

What Lifestyle Do I Want In Retirement?

Picture the waves rushing over your feet as you stroll down the beach, the sea breeze flowing through your hair, and the warm sun beating down on your back. The flexibility to travel when you like, to eat amazing food, to have a large house, a tennis club membership, two sports cars, and to be surrounded by friends and family. Perhaps that’s your idea of a perfect retirement – or perhaps not.

One thing’s for sure – you don’t want the retirement where you are sitting in the cold to save on energy bills, worrying over the next meal, and unable to spend money on the things you enjoy.

Have in mind the lifestyle you want. If you don’t, you’ll be like a rudderless ship, moving whichever way the tide takes you. Decide what you want, then work towards it.

How Much Annual Income Do I Need?

Once you’ve decided on the life you want, the next step is to calculate how much it costs. Think about your cost of housing, food, energy, cars, healthcare, holidays, gym memberships, other subscriptions etc.

Add up the costs in today’s money and calculate what you need per year.

Remember that you will have to pay some tax on your pensions. Also remember that, if you qualify, you will receive some state pension from around age 68. Today’s full state pension is £9,600/year, rising with inflation.

Let’s say that, in today’s money, you need £30,000/year as a pension income (beyond the state pension) to fund your lifestyle. That £30,000 will grow in time with inflation - but it’s simpler to work with today’s numbers.

The next step is to work out how large a pension pot you need, in order to generate £30,000/year income.

How Large a Pension Pot Do I Need? Follow the 3% Rule

Let’s outline the 3% rule: if you’re invested properly and for the long-run, you can withdraw 3%/year from your pension pot, without eroding the real terms (inflation-adjusted) value of your wealth.

How does this work? A long-run equity portfolio can be expected to generate ~6%/year, and inflation typically averages 3%. That means that of your 6% return, 3% goes to covering off the effect of inflation, and 3% is leftover to spend. Hence the 3% rule.

Investment returns are not stable. You may have some years down 30%, and other years up 40%. But on average, an equity-focused portfolio should return 6%/year.

If you spent the whole 6%/year, your investment portfolio would be the same size at the end of the year as it was at the start. But prices would have risen by 3% with inflation. That means your pension pot, adjusted for inflation, would be worth 3% less at year end. The 3% rule is a good compromise to prevent you from running out of money.

Using the 3% rule, if you need £30,000/year, your pension pot needs to be £1,000,000. (3% of £1,000,000 gives you £30,000 – this is your annual income).

If you need £15,000/year of income above the state pension (a modest retirement), your pension pot needs to be £500,000.

If you want a more comfortable £60,000/year, you need a pension of £2,000,000. This would be luxurious.

How Much Should I Contribute Today?

Let’s continue with the £30,000/year desired income. How much should you contribute today?

Under the 3% rule, you need your investment pot to reach £1,000,000 in today’s money, and your investment return will be 3%/year after adjusting for inflation. Let’s assume you retire at age 68.

With these assumptions, we can observe the following:

• If you start saving at age 21, you will need to save £830/month to hit your retirement goal of £30,000/year income in today’s money. Bear in mind that this includes your employer’s pension contributions as well as yours

• If you start at age 30, you need to save £1,940/month

• If you start at age 40, you need £3,560/month

• If you start at age 50, you need £9,370/month.

This is for a good retirement with £30,000/year in today’s money – not for a life of luxury. It’s clear that the earlier you start, the less you need to save each month, as compound interest works in your favour.

If you want to retire earlier than 68, you need to save more, but it’s doable.

If, however, you don’t save into your pension until your late-40s, you’ll be slaving away just to fund a basic retirement.

If I Contribute X, How Much Income Will I Have in Retirement?

Another way of looking at pensions is to say ‘if I contribute this much per month, how much will I have in retirement?’. Let’s take a look.

Assume you begin your pension savings at age 25. If you and your employer contribute £200/month into your pension, you’ll have £205,000 by retirement, in today’s money. Under the 3% rule, that will give you £6,150/year in pension income, plus the state pension. Enough to scrape by, but not much more.

What about £500/month? You’ll hit £513,000, enough for £15,400/year in retirement. Not bad, but no luxury.

And what about £1,500/month? You’ll hit a pension pot of £1.52 million, enough for £46,000/year. A luxury retirement…

It doesn’t matter which way round you think. It can be ‘based on my current contributions, how much will I have by retirement?’. Or it can be ‘based on what I want for retirement, how much do I need to contribute’. Either way, you’ll be mapping out your financial journey.

How To Win

As with anything – sport, art, business, etc – succeeding with money is about visualising what you want and then making it happen.

It can be tempting to prefer not knowing – that awful phrase ‘ignorance is bliss’. But by not knowing where you are on your financial journey, you’re just storing up today’s problems for tomorrow.

It’s also worth remembering that £1 invested into your pension now isn’t the same as £1 invested in 20 years. The sooner you invest, the longer your money has time to compound in your favour.

One thing is inevitable – you’ll need a pension for retirement. So you can either think about it now, or it will come for you later and make your life difficult.

In the long run, you’ll be glad that you decided to plan your work, then work your plan. But today, right now, the choice is yours. Take charge of your pension, otherwise it will take charge of you.