To calculate how much you'll need to live on when you retire, and how much you should save to achieve that, read this. You probably need a lot less than you think.
How much should you save for retirement?
Think about these two things:
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On average our incomes will more than halve when we retire.
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We overestimate what we're going to get by 40%, because we don't invest enough.
However, I'd like to build on that by saying that we don't need as much money when we retire as we think we do, because our costs in retirement are a lot lower. Anecdotal evidence suggests many people live comfortably on around £10,000 per year.
The industry often talks about the magic target being £20,000pa. The truth is that we're all different and therefore we'll need different amounts. One thing is certain, my calculations find that £20k is waaay too much for most people.
The point is that it's individual so, rather than pile stupid amounts of money needlessly into your retirement pot, why not work out how much you (and I mean 'you', not the average person) will actually need to live on post-work?
Do your exercises
I devised an exercise to calculate that very thing in The Four-Step Guide To A Comfortable Retirement. (The first part was published on 11 June 2007.) In the guide I said you should re-visit the exercise at least once a year to ensure you're retirement pot is still on track.
If you're like me and you have a good idea of how your funds are performing, the great news is that you don't really need to conduct the exercise in full every single year. If you think that changes to your circumstances have been small, you can just glance over the first step of the guide.
Make a note in your calendar to re-visit it again in another year. I'll probably conduct the exercise in full every two years.
Building on the four-step guide
One year later, I have no refinements to make to the exercise. However, I have a few more points of interest:
ISAs and final-salary schemes
The first of these points is that this exercise isn't exclusively about pensions. If you're saving for retirement using ISAs, for example, the same principles apply. However, if you have an old, final-salary (aka 'defined-benefit') scheme then this exercise is probably inappropriate for you.
Consider how your retirement investments have performed
I'm loathe to draw your attention to the performance of your retirement funds after just one year. Saving for retirement is a rocky road of ups and downs which, if looked at too frequently, can freak you out and lead you to make wrong or rash decisions.
Your 'investment graph' will zigzag, but over many years the zigs up will most likely be larger or more frequent than the zags down, so that over a long time and from a distance (so that you can't see the fluctuations) it should look something like this.
So remember that retirement planning is for the long-term; you don't necessarily have to be concerned if you've lost a load of money this year, provided you're not retiring next week!
However, you should still re-do the exercise based on your current pension pot. Ask your pension providers how big your pots are.
If you think there's a shortfall now, you might consider contributing a bit more, but remember that ups and downs are normal. It may be too early to take such action, so have patience.
If your investments have done very well, you may be tempted to reduce your contributions. However, it may be that next year your gains are wiped out by one of the frequent down zags, so it's best to leave it for the time being.
Late starters
I would say if you've started saving for retirement late and have relatively few years left before you retire, you should save more than you calculate you'll need to, to be on the safe side. This is because over shorter periods investments are more likely to underperform.
If you're starting very late, e.g. you have just ten years left (or even perhaps fifteen years), it may be too risky to start investing your money now. A better strategy might be to pay off your mortgage as fast as possible. We talked about starting a pension late, and alternatives to doing so, in How To Build A Healthy Pension Pot - Whatever Your Age.
What should you invest in?
What you invest in will make a difference too: we can't assume we'll all make an average 7% per year! The trick is to spread out your investments so that you're not being too risky. In this way your graph should, over twenty to forty years, look like that one I linked too, with relatively little luck!
Finally, once you've done all this and your retirement approaches, join our Get ready to retire goal for hints on tips on making the all the right financial decisions when the time comes to hang up your boots. And for even more help on preparing for the all important day, don't forget you can ask the lovemoney.com community for help using our excellent Q&A tool.
This article is a lovemoney.com which has been updated for 2010.