How much is enough when it comes to your pension?

Working out just how much you need to put into a pension is a bit like one of those old school maths questions about the time that a train will arrive at its destination given its running speed and the stops it’s scheduled to make along the way.

The main difference is that, when it comes to calculating the size of your future pension pot, the income that it will deliver and how long it’s likely to last, you’ll need to allow for additional factors such as:

  • The fact that the ‘train’ never runs at a consistent speed for any length of time;
  • That it can change direction without warning; and that
  • There’s an unspecified number of stops that can change as you go along!

This is because no one can predict how their investments will fare in the future and in the short-term investments can fall in value just as easily as they can rise. It also illustrates how no one really knows when they might need to dip into their pension fund or how much they might need to take.

In fact, you can’t even rely on the age at which you’re likely to be allowed to access your pension pot – which adds yet another wrinkle to the problem. After dipping as low as age 50 in recent years, the age at which Britons can currently access their pension pots was reset to 55 in 2010, but its likely to climb ever higher as we all now insist on living longer and longer!

Clouding the waters

These are just a few of the problems with working out how much you need to put in a pension and there are numerous others.

Down the years, a great many formulas have been offered by pension companies, advisers and the media that try to illustrate how much you need to save into your pension. One example that’s still doing the rounds is the notion that you need to save a percentage of your gross salary that’s equivalent to half the age you were when you started your pension.

On this basis, someone earning £40,000 a year who starts a pension aged 40 would need to contribute a whopping 20% of their gross salary or £8,000 a year (about £670 a month)! Naturally, this particular formula looks still more strained as you increase the age of the saver in question.

The other problem with this and similar formulas is that, in order to calculate the level of income a pension pot can provide in retirement, they incorporate current annuity rates. And there’s a big problem with this.

Old think…

In terms of our earlier train problem analogy, factoring current annuity rates into a pension pot calculation is a lot like changing from a high-speed train to Stephenson’s Rocket in mid journey. Thanks to an era of super-low interest rates, UK annuity rates have collapsed to the lowest levels in their 300-year history. In fact, margins are now so low that many of the UK’s former annuity providers have simply closed up shop.

These days, someone who’s worked hard throughout their life to build a £100,000 pension pot – which is about four times the current UK average – could at age 65 exchange it for a guaranteed ‘single life’ annuity that would deliver a monthly income of just £2141. This is precious little to show for a lifetime of saving (especially as the income paid by a single life annuity ends the moment the buyer dies).

New think

The alternative to buying an annuity that will be of far more use to most of the UK’s coming crop of retirees is called income drawdown. Under an income drawdown arrangement your pension pot remains invested throughout your retirement and you literally ‘drawdown’ the level of income you need (subject to the tax rules).

Of course, this means you bear the investment risks yourself but assuming even modest invest returns on your pension pot will allow you to draw a far higher level of income than you would receive from an annuity while still seeing your underlying pension pot grow over time.

In the case of our 65-year old man above, if he chose to ‘drawdown’ the same £2,570 a year that an annuity would deliver, his projected pension pot would have grown to be worth £137,610 by the time he reached his ‘expected’ life span of 83 (assuming an annual growth rate of just 4%).

If he made it all the way to age 100, his fund would be worth well over £200,000 even though it had already paid out some £90,000 in income since he turned 65. Unlike an annuity, this pot could then be passed down to his beneficiaries.

1 Based on open market annuity rates available as at 23 May 2017.

Calculate to accumulate…

The only reliable way to really get to grips with how much you should be contributing to your pension is to work out how much your current contributions will deliver by the time you reach your target retirement age and to adjust accordingly. Of course, you’ll need to make a bunch of assumptions as to the growth rate your pension savings (including tax relief) will achieve until you reach your target retirement date.

Once you’ve arrived at a notional figure for your pension pot at some point in the distant future, you can set to figuring out the income it will provide and how long it’s likely to last (this will require more assumptions about growth rates and some educated guesses about your expected lifespan).

Of course, all this is far beyond anyone who isn’t a pension actuary. That’s why Drewberry have created a Pension Calculator. It’s an indispensible tool for anyone trying to shed light on just how much money they can rely upon in retirement.

You can choose any level of potential contribution and because it incorporates a range of projected growth rates for both the ‘accumulation’ and the ‘decumulation’ (namely the income withdrawal) stages of your pension, it will also show you just how long your notional retirement fund is likely to last.

The new ‘rules of thumb’

Ultimately, the only rule worth keeping in mind when it comes to how much you should be putting in a pension is ‘as much as you can afford and for as long as possible’.

Don’t forget that the tax relief paid on UK pensions is probably the most valuable benefit you’ll ever receive from the government and one that will surely be reduced in the coming years.

This means that, especially as you get older, you should think of your pension as the first port of call whenever your finances improve or you come by a windfall of one sort or another. Thanks to the tax relief on offer, there’s a good argument for those savers who have reached their forties and fifties with significant ISA portfolios to reinvest part of these savings into their pensions as they’ll benefit from a significant tax relief uplift and have full access to the funds again by the time they reach age 55.

Remember, most Britons can invest up to £40,000 a year in a pension (or their salary if it’s lower). But because very few of us contribute anything like this amount, you can also top up your pension with additional lump sums that mop up any unused annual allowance in the last three years. This opportunity to ‘super charge’ your pension is called ‘carry forward’.

When it comes to working out just how much you need to put in a pension these days, getting to grips with carry forward will be the final part of the puzzle for many of us.

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