Saving for retirement is tough, but not nearly so tough as getting started in the first place. To get going you need a retirement plan. To get motivated you can try putting some numbers through a pension calculator.
Did that? Disappointed the predicted outcome falls hopelessly short of your expectations?
You’ve got two options. One is to find a big bucket of sand to stick your head in. The other is to set your face against stony reality and work out a Plan B.
I think you know what to do…
A fine example of a plan
There now follows a pension calculator comic strip showing how a failing plan can be put back on course. But first some plot exposition.
Our hero is Corporate Colin. Colin works for da man, slaving away for 30 grand a year as a counter of bean counters in Nowhere Business Park.
Colin is 30-years-old and if he can pull three cherries on the defined contribution fruit machine then he’d like to retire on £20,0001 a year, age 65, in 2047.
2047 – that’s 35 years from now. This thought alone is enough to make Colin reach for the cyanide pills but luckily he stumbles across Monevator while conducting an online price comparison and rediscovers his joie de vivre through the medium of simple investment wisdom.
But I digress. Colin harbours some other dark secrets that you should know:
- He intends to divert £300 per month – or 12% of his salary – into his pension fund.
- That maxes out his matching employer contributions at £150 per month, or another 6% of salary. The calculator assumes that contributions and wages will increase in line with inflation (defined as 2.5% a year).
- Colin’s existing pension assets are zero. Which is slightly higher than his level of respect for his boss.
- Colin has a wife and though he can’t understand how she’d want to live without him, he nevertheless selects the 50% spouse annuity option, just in case. That means his significant other will soldier on with 50% of the income in the event of Colin’s untimely death.
- Our protagonist has even dared to read the calculator assumptions, just in case there’s some hidden knowledge buried in there that he can turn to his advantage.
- He understands that the income projected by the retirement project-o-tron is based on annuity assumptions that will probably bear no relation to his situation in 2047.
- He’s happy to have his income index-linked at 3% a year when he retires because he wants to be able to afford beer at £60 a pint in 2067.
- Colin is keeping his state pension out of it. He’s going to get a forecast done, but wants his state pension to be a buffer in case things go horribly wrong.
- In the nick of time, Colin remembers that his £20,000 retirement income will be taxed. A quick spin on a tax calculator reveals that Colin will be living on £18,100 a year, after tax, at age 65. Colin can accept this. It’ll be 2047 after all and the tax system may well look very different. What can you do?
Colin tires easily and can take no more assumptions. So let’s get on with it.
Fire One – The range finder
Colin enters his numbers into the calculator and dreams of a world without emails marked URGENT!
Disappointing. An income of £20,000 after 35 years didn’t seem a lot to ask for but nonetheless, our Col has pulled up short. If he doesn’t take action then he’ll be living on £15,000 – which is 75% of the desired amount.
A diet of Aldi spam doesn’t sound great, so let’s consider some alternative scenarios.
Doing nothing is not one of those scenarios as the ‘delaying for five years’ part of the calculator tells a chilling tale of penury. It really is now not never for our hero.
Fire Two – Reduce costs
As a good passive investor, Colin will use cheap index trackers to hammer down his investment costs. So he goes into the calculator’s advanced options and turns the annual management charge down from 1% to 0.5%.
That move alone makes a pretty big difference – projected income is now nearly £17,000 – but at 84% of the target Colin needs to do more. It’s time to suck down some more painful solutions.
Fire Three – Working longer
With a deep breath, Colin dials away a few more years of his life and delays his retirement age.
Putting another three years onto his working life and retiring at 68 does the job for our masked wage slave.
It amounts to no more than the push of a button now, but perhaps working for longer as a part-timer may be less painful when it comes to the crunch. The £21,000 income is a wiggle-room bonus.
Fire Four – Saving more
“No chuffin’ way am I working for those vampires a moment longer than I have to,” thinks Colin in a rare flash of rebellion. How much more do I have to save for retirement to get out at 65?
Colin’s contributions must go up by another £100 every single month for the rest of his working life to hit his target income by age 65. Though that’s only £80 in actual spending money, thanks to tax relief.
Fire Five – Live on less
Can’t save more, won’t save more? What about getting slash happy on the target income? What difference will that make?
Colin has to shrink his living expenses to £16,700 a year to make his plan work. That’s a steep 16% drop.
There is another string to pull though. It’s marked ‘hoping for the best’…
Fire Six – The big bazooka
The calculator currently assumes an expected annual return on investments of 7%.2 Colin dances with the devil in return for a growth rate of 9%.
Wow. All Colin’s problems are solved! The projected income shoots up to £32K per year and the target is busted.
Is 9% per annum possible? Yes, but it’s massively risky to bank on it.
Historically a 60:40 equities and bonds portfolio has averaged 7%. But many are predicting sub-average returns over the next decade or so, especially as bond yields have sunk so low. Investors starting in the early 1980s could have comfortably scored a 9% return, but history has not been so kind to market entrants in the Noughties.
You can see how different asset allocations have faired using Vanguard’s Asset class risk tool. (Click on the grid icon when it loads).
The bottom line is that the more you shoot for the stars, the better chance you have of hitting yourself in the foot.
Fire Seven – Trench warfare
As an antidote to the intoxicating temptations of a 9% return, Colin takes a quick look at the 5% per annum return scenario – and promptly chokes on his digestive.
Shocking. Earning a return of 5% a year instead of 7% shatters Colin’s dreams. The projected income of £8,600 is 57% less than he needs and would amount to a catastrophic failure of the plan.
This is the nightmare scenario and it can happen to the cautious and adventurous alike. The prospect of low growth is why most of us must bear risk through our asset allocation but the markets can’t be trusted to behave as we would like.
So don’t be over-optimistic, do all you can as soon as you can, and hope it doesn’t happen to you.
Fire Eight – The scatter gun
Suddenly 7% expected growth doesn’t look so bad, but it still leaves our office survivalist battling to close the retirement income gap. Perhaps the medicine will seem less harsh if it comes in smaller doses?
That does it. By working one year longer to age 66, upping the savings rate another £25 a month (only £20 with tax relief) and cutting income expectations to £19,000 a year, our hero is finally able to create a palatable sacrifice sandwich that doesn’t make him baulk.
Fire Nine – More ammo!
Remember that any retirement plan is about as precision guided as a SETI sweep of the stars in search of ET. Don’t be fooled by the ludicrous exactness of projected income figures. Reality will turn out differently.
Even using a different calculator may get you a very different answer, though the assumptions may seem similar.
Trustnet’s pension calculator projects a much rosier income of £25,000 per year based on Colin’s original inputs and a 7% growth path. But the Hargreaves Lansdown calculator used for the main example is the most transparent one I’ve found when it comes to assumptions and adjustable parts.
Do let us know about your favourite calculator in the comments.
Fire and don’t forget
Your plan will need monitoring and deft touches on the rudder to stay on course:
- Lifestyling – You may want to lower the risk in your portfolio as you get closer to retirement. Bear in mind this may also reduce your growth rate.
- Rebalancing – This technique enables you to stay true to your original asset allocation when market movements cause it to drift.
- Changes in circumstances – Promotions, inheritance, periods of unemployment, and the rest of life’s rich tapestry may prompt you to revisit your plan and adjust your expectations.
- Unexpected growth rates – Periods of spectacular gain or loss may demand a rethink. Maybe you’ll be able to reduce the risk in your portfolio and cruise home in style if the markets smile upon you. Maybe we’ll end up with the 5% (or worse) nightmare scenario and have to work longer, save more, and live on less. I hope not.
If nothing else, an exercise with a pension calculator shows what a grueling marathon building a retirement pot is for the average wage earner. See you at the finishing post.
Take it steady,
The Accumulator
Great post. Love your blog.
Like Colin, I’ll be 30 soon, earn a little over £30k and am not necessarily the biggest fan of work.
Putting my ideal retirement age of 55 into the calculator was a sobering experience, even though I’d be aiming for a far lower £10k income (as I’m expecting no mortgage expenses and £2k/year from a small civil service pension).
For me, putting my faith in the world of pensions is very difficult and I’d rather retain direct control of as much of my money as possible.
Wouldn’t Colin be better off paying £150/mth into his pension and another £150/mth into a lower cost tracker held in an ISA? Granted, this involves the application of additional willpower.
I’d like to see an article on the alternatives to a pension, maybe with some scenarios for us to compare and contrast 🙂
@ Luke
The advantage of pensions is the free extra money from the government (in reality your taxes refunded) and your employer right put in at the start of the investment period when it can do most good through compunded returns
The article above skims over the extreme volatility in returns needed to make a 7% real return
As an example if you get 20% basic rate tax relief and your employer will match your contributions up to 6%
Altogether that free money is worth about 25% more than you can put in a pension
That’s about 3 1/2 years growth without any risk
If you are a higher rate tax payer and your employer is more generous, maybe through putting some of the NI they are saving in, you quite quickly get to the position where the amount you are putting into a personal pension is doubled on day one, with no risk
This is why personal pensions are a better investment than an ISA
Its really a joke how much better the current pension contribution rules are to higher earners
I am in a similar position to Luke and am putting the minimum into my work pension to maximise the employer contributions because the fees are 1%. I’m investing the rest into low cost trackers inside ISAs at around 0.3% fees. However when I become a higher rate tax payer I may put more into my pension or a SIPP because I’ll get 40% tax relief on the contributions which will be hard for an ISA to match. However that does mean losing access to that money until i’m 65 or more which isn’t ideal, as who knows what will happen to the pension landscape over the next 35 years?!
Employer contributions are one of the biggest free lunches in investing, and higher-rate tax relief is a close second.
However it’s worth remembering that in most ways ISAs and Pensions offer the same sort of tax benefits — just at different points in your life cycle:
http://monevator.com/pensions-versus-isas/
Besides employer contributions, there are a few other things potentially favouring pensions.
The big one is the tax free lump sum. If I was Colin in the article I would certainly take my 25% lump sum tax-free, even if only to immediately invest it in, say, some income generating investments outside of the pension. That’s tax relief in AND out of the pension, rather than the usual taxed pension income, so effectively free money.
In addition, while the government isn’t adverse to meddling with pensions in all sorts of ways, I think it’s likely they’ll always be around in some form, and they may sit outside means-testing and the like in some unknowable future. So worth diversifying between them and ISAs I think for that reason, too.
But is higher rate tax relief not only a benefit if we assume that we won’t be a higher rate tax payer in retirement? I.e. you gain tax relief at the higher rate and are then taxed at the lower rate at the end of your working life?
Hadn’t thought about the lump sum properly before, that’s definitely a big win.
Ps. Before anyone else mentions the magic of employer contributions, I’m sold and (like Ash), pay just enough to get the maximum match.
@Luke — Yes, but that’s the situation many people are in, even higher earners, at least according to the research I’ve read. I haven’t done the maths in detail, but you’d be looking at a pension pot worth something like £1 million in today’s money for the typical male retiree to get an inflation-linked pension income that’s subject to higher rate tax today, judging by annuity rates.
Few will achieve that (I aim to!) which means there is a tax benefit to getting relief at 40% and being taxed at 20%.
In fact, higher-rate tax relief is seen as an anomaly that favours the wealthier, by some politicians, who say it isn’t government’s place to subsidise them with a higher standard of living in retirement. So far all that sabre rattling has come to nothing, though. (That won’t stop financial firms using it as a bogeyman to encourage more pension contributions come spring, however…)
(Of course, all rates could change by the time a 30-something of today retires, so as we’ve all agreed I think, spread your money about. 🙂 )
@Ash G – you don’t have to wait till you’re 65 to get hold of the money. Current rules are that you can access pensions at 55. This doesn’t apply to your state pension, and it may not apply to the occupational pension provided by your employer – which could well have its own set of rules about when you can access it – but it does apply to other pensions, e.g. stakeholder and SIPP pensions. So there’s nothing to stop you setting up different pensions to access at different points in your life from 55 onwards.
Also, I second Neverland’s point about what tax relief implies for returns, and you don’t have to be a higher-rate taxpayer to make them worth having. Even as a basic rate taxpayer every contribution you make into a pension gets an immediate 25% return (£20 is 25% of £80), aside from all the compounding of investment returns over the years etc.
And The Investor’s right about diversifying – in retirement I’d ideally want several different income streams (just in case!) so that’s what I’m putting in place.
@Tyro –
Thanks for the comments re. accessing SIPPs earlier than workplace pensions – could be a great way for me to bridge the gap between stopping work and retirement proper (can access my pension at 65).
Throw some ISA contributions into the mix and hurrah – phased retirement income on my own terms!
Great comments on this post.
Isn’t there some room to play the tax thing by targeting a pension income of around the tax threshold (say 10k in today’s money) and using ISAs for the excess? For many people in lower HRT band that probably optimises their taxation position, as they get HRT help on saving into the pension and their ISA income doesn’t for part of their taxable income in retirement.
You pay tax on a pension, though not NI I believe. Certainly the taxation in retirement is a consideration for me – only in the period between retiring and drawing my pension will I be a non-taxpayer, something I aim to take full advantage of. However, the disadvantage of deferring my pension is I get to pay more tax on it when I do get it 🙁
@ermine — Definitely worth thinking about. However given all the unknowns — legislative changes, uncertain investment returns, life changes, interest rates when you retire, the future level of the state pension — that could happen over 30 years, I think trying to finesse how you invest around pensions is best targeted at the front end, rather than trying to ‘game’ the future income you draw from it.
For instance, instead of paying higher rate tax on a portion of my salary this year, I would make additional pension contributions (and benefit from higher-rate tax relief) sufficient to use up my 40% rateable earnings. At least I’d know it’s in the bag that way.
In contrast, you could imagine someone in their 50s in 1999 thinking their £10K pension projection (for instance) was a slam dunk and switching off their contributions, only to see two bear markets or what have you knock them back.
Great series of articles – most folk are sleepwalking when it comes to pensions / retirement. My own wake up moment was being made redundant at age 45 and starting to do the arithmetic as you show above – this made me realise just how far short I was. Since then it’s been a dual approach of ISA contributions and additional pension contributions. That was almost 10 years ago – the goal is at least in sight now.
As you show it all comes down to working out where you want to get to (financial plan – how much you need) and then taking a look at the investment risk profile you need / are comfortable with to get there and then making some choices.
In my case there’s quite a few bits to this with a mixture of final salary (smallish), defined contribution pots,state benefits in pension and trackers /HYP in ISAs and the choices that go with where / what to invest this lot taking risk profile into account.
As ermine points out ISAs offer a tax free potential income stream, this together with taxable pension should help minimise taxable income when you retire.
Even for 20% (while working) taxpayers its worth aiming to build a pension pot that provides a 10k income. I estimate you need a pot of at least a third of a million before income tax is even an issue, assuming all other income producing assets are wrapped in ISAs. Eg take the 25% TFLS (to bung in ISAs) and then you’re left with 250 grand which could be used to drawdown a 10k income (4%) whilst staying invested.
I’m ignoring state pension here as the govt will just keep pushing that further out until you’re in your 70s. It will end up being a top up to help counter inflation in the second half of your retirement.
For 40% working taxpayers its an even better deal, to the point where I’m considering stopping further ISA contributions until I’ve
hit that initial £333k target for my SIPP.
But my gut feeling is that a future govt will do away with this perceived advantage that higher rate taxpayers have on pension relief. It may be under threat as soon as 2015. The 50k annual amount could certainly be reduced.
Another plus point for workplace pensions is salary sacrifice. If your employer is generous enough to pass on 100% of the savings on NI contributions (and there is no reason for them not to pass on these savings really) then it can soften the impact of pension contributions on your income. More free money.
Ok, so here are some actual nos. to show the superiority of pensions to higher rate tax payers vs. ISAs
I contributed to a variety of personal pension schemes (Now amalgamated) with employer contributions and higher rate tax relief for a total of 15 years
Average annual return on my net (i.e. actual contributions) = c. 16% per annum
Average annual return on gross contributions (including tax relief, some employers NI contributed and employer contributions to scheme) = c.8% per annum
The point is that my return was roughly doubled with tax relief and employer contributions in one form or another
ISAs won’t make you close to this return and the higher rate income tax at the other end is not an issue for anyone with a fund under £1.5m in today’s money
The only thing that can make you money like this is a highly leveraged bet on residential property, which is much more risky IMHO
@Neverland pension contribs are a no brainer for HRT taxpayers, there’s an argument to be said for never letting your lifestyle outstrip an income of about 42k each and lobbing any extra into a pension 😉 Likewise employer contributions are always worth having. However, after you’ve brought your income down to the HRT threshold, which will probably also get you employer match, then there’s a case for considering the ISA option too to minimise post-retirement tax, assuming you’ll reach the roughly £250,000 in real terms pesnion savings that would give you a pension up to the personal allowance.
An exception to that is salary sacrifice, where you get an effective boost of 32% even below the HRT threshold, all the way down to the personal allowance. I nearly got my salary down to the 8k mark a couple of years ago and drew on savings to fill my ISA then. Saving 32% on the way in and eating a 20% hit on the way out is still a gain. I note, however, that there are rumblings of integrating the tax and NI systems. It will be an easy way to soak the rich pensioners of which there will be more in future, relatively speaking, so I can see the temptation for cash-strapped governments in coming years, so I still feel that aiming for a pension (as opposed to retirement) income of more than the personal allowance is a gamble unless you’re paying HRT.
However, the key win for that was having killed off my mortgage, and it was still a serious challenge. You don’t get to go on holiday living on less than minimum wage, so it’s only an option in the final push to retirement, else it just does your head in!
Excellent commentary on this article… glasses of bubbly all around… If I was YoungPro in my thirties I’d be a (even haha) richer OldPro in my Old Age after acting on such insights… I would be IF I had acted on such insights to be truthful…!
You can tell the young… but you can’t TELL the young…
I’m enjoying this thread, good work people. The national insurance contributions mentioned – if those are swept into your pension, aren’t you giving up your entitlement to the State Second Pension?
Right now it makes total sense to me to diversify tax shielded assets between ISA and pension. But I imagine in the 5 years or so before retirement I’ll be stuffing everything I can into the pension, up to the maximum allowance, including ISA holdings if need be, so I can maximise the 25% lump free sum.
While retirement is still distant, my ISA holdings = flexibility. My need for that will diminish as I approach retirement and I might as well capture as much of the tax advantages of a pension as I can. Assuming it still exists.
@TA You’re a young chap from the examples, probably 10 years off retirement at the very least 😉 You shouldn’t be counting on the SSP because it’s going to be canned by the time you get to the moveable feast that is the SP age. On the upside the SP goes up a bit to £140.
You are right that forcing your income to below the NI LEL (a lot lower than the tax threshold) ceases your accrual of SP years, and more subtly your entitlement to some benefits like contributions-based JSA (which will be canned in universal credit anyway next year). I believe an employer is not allowed to pay less than the NMW (my sharesave contributions should have been added to the 8k+, I was on just above NMW in total due to sal sac). So it is only part-time workers that can reduce their pay to below the NI LEL that way.
It’s possible that I’m being really thick here, but
puzzles the hell out of me. You’ve already paid tax on the money you can stick in an ISA. Say you have a SIPP capital of £250k giving you a income of £10k p.a. in line-ish with this article – divide by 25 rather than 22. You break out 62k pension commencement lump sum (PCLS) of this, so your taxable income is 7.5k and tax-free (from the PCLS, once you’ve got it into ISAs over the next 6 years) is 2.5k. You now wander along with your ISA savings of £100k, say. They would give you a tax-free income of £4k. Total is 7.5k + 2.5k + 4k = 14k.
Instead, you lob 100k ISAs into your pension, total is £350k. You spring 87.5k PCLS out of this, leaving you with a taxable income of 10.5k and non-taxable of £3.5k, after 8 years of shoving back into ISAs. If you’re below the tax threshold at the time then there’s no difference, apart from you being at risk of a tax grab in retirement. If you’re above the tax threshold you start to lose out on that move by increasing your taxable income, and losing the ISA sheltering you built up over 10 years. Or is there something I am missing?
Don’t get me wrong, the PCLS is useful, I’ve saved well over a year’s gross into my AVCs with the express aim of drawing it out again as a PCLS, but it’s the unsheltering of tax-paid and tax-sheltered ISA cash that I don’t understand here?
@ Ermine – the thought was that I’ve already paid 20% – 40% tax on ISA contribs but won’t be taxed on income. Then I put them into the pension and get tax relief on that amount but will be taxed on income. So it’s neutral from a tax point-of-view (if I’m over the personal allowance threshold but not in danger of breaking through the 40% barrier), except I can take a larger 25% tax-free lump sum. And it’s better than neutral on the contribs that were taxed at 40%, if I expect to be taxed at 20% in retirement.
It’s just an idea really, I haven’t thought through the ins and outs. I’m just throwing it out there to see if there’s an obvious blunder that someone can point out.
hi
the link to vanguard risk tool in this article is dead:
https://www.vanguard.co.uk/uk/portal/indv/investing-truths.jsp#the-truth-about-risk
It is impossible of course for you to maintain the links in all your articles, but I wonder if there are ways to organise ‘community support’ to help maintain the currency of the website. Other blogs with good longevity and strong readership may provide models to transition to a more permanently manageable form. I guess it is a question of scale – I don’t suppose monevator is ever going to be the size of moneysavingexpert and be bought out by big business; on the other hand open software projects like R, gnucash and LyX are wholly maintained by community efforts, so perhaps these are good models for long term sustainability.
@IanH — Thanks for the heads up. Links are indeed always dying, and it matters more for some articles that others. (Here it clearly matters!) Not sure as you say what can really be done about it, short of being notified by kind readers like yourself.
I’ll leave Mr Accumulator to replace this link with a new decent one when he gets the chance.
In general I’m aware of a massive body of old articles that need updating. (I’ve had Capital Gains Tax articles on my list for weeks now!)
Link updated! Sorry it took so long.