The Three Key Pension Questions
There are three key questions to ask if you want a comfortable retirement. Answering them is not so easy, but one Fool gives it a go.
I'd like to start this article on a positive note and Scottish Widows has given me just the opening. Its survey of nearly 6,000 showed that, on average, people think they need £30,000 a year to live comfortably in retirement.
I'm not as pessimistic as that. Assuming you've got no debts and you've paid off your mortgage, I think a pension 'salary' of £20,000 is sufficient for most people. After tax (but not National Insurance as you stop paying it when you start taking your state pension) you'd have a net monthly salary of £1,300. It's a modest amount, but a prudent pensioner could live on this, regardless of where they live in the country.
So what's the bad news? I need to take a deep breath to answer that, I'm afraid. Scottish Widows reckons only one in twelve of us is saving enough to retire on what we think we need. Also, as our life expectancy increases we'll need larger retirement pots, because the money will have to spread over more years. Furthermore, the Scottish Widows survey found that people hope to retire at 62, which means a substantially bigger pot is required than if you retired at 65.
What we have to do is work out what annual pension income we think we'll need to live comfortably when we retire. We then have to work out what pension pot we think will secure this. Then we must consider how we're going to get that pot.
1. What will be a 'comfortable' retirement income in the future?
As I said, I reckon most of us could be comfortable on £20,000 per year if we retired today with no debts. Now we factor in rising prices (inflation). Assuming prices rise at 2.5% per year on average, a 40-year-old will probably need £37,000 per year and a 25-year-old about £54,000.
2. How large a pot do we need to get this comfortable income?
If you retire today at 65, you need a pension pot of about £400,000 to produce a pension of £20,000 per year, but this is a very rough figure. The problem is that there are so many variables to take into consideration, such as your gender, whether you want your spouse to benefit after you die and whether you smoke. It also depends who you buy your annuity (your monthly pension income) from and whether you want the annuity to increase each year.
If you're not retiring for some time, there are even more variables, many of them unknown. Our life expectancy is possibly the biggest of these. There are hundreds of cures and technologies which might be realised in the next few decades: a universal cure for cancer or viruses (including AIDS), a technology that slows the ageing process, or perhaps car safety features that will halve the road accident death-rate. All it takes is for one or two of these to come about and be deployed nationally before we see average life expectancy advance five years, or even a lot more! This means that our pension pots will have to be a lot larger in future.
I did a few sums to see what we might need in our pension pots to live comfortably if our life expectancies increase by just five years. I found that a 40-year-old male might need £850,000 if he wants to retire at 65. Women, younger people, and people who want their spouse to benefit from their pension after they die could easily need well over £1m. OK, this calculation is based on a hell of a lot of assumptions, not the least being what you consider to be a comfortable income! However, it's still a scary thought.
3. How do we reach a pot of this size?
I can't stress clearly enough that the above figures are based on lots of assumptions which may not be true for you, or accurate in the future. However, it should give you a better indication of just how much you might, and probably will, need. So how do you get it?
The standard advice is, if you're just starting to save for your pension now, you should halve your age and contribute that amount as a percentage of your salary. Therefore, if you're 30 you contribute 15% of your gross salary (including employer's contributions and tax relief) for the rest of your working life.
Ian Naismith, head of pensions market development at Scottish Widows reckons that we should contribute at least 12% of our earnings every year from age 30 to 65 in order to secure a comfortable retirement.
Personally, I'm more pessimistic. The thinking behind both of these calculations are based on a lot of assumptions - just like mine earlier. If any of these assumptions turn out to be inaccurate, it could seriously mess things up. For example, income tax on pensions may increase, inflation may be greater than we expect, our life expectancies might leap five to twenty years, companies that provide annuities may start offering lower pension incomes, investment returns in our pensions might be poorer than expected, and so on. Too many assumptions!
Consider that if you're going to live for twenty, thirty or more years after you retire, you'll want to live well. My advice is, if you're relying solely on your pension for retirement, you might want to err on the higher side. If you can save more than the standard advice recommends, you should do it.
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