Saving for an adequate pension is no easy task. It takes a lot of discipline and commitment over many years against the headwinds of inflation to achieve an amount of money needed to see out your later years, a number that can seem frankly mind-boggling. So can some relatively minor tweaks along the way alter the course from a frugal retirement into one of moderate luxury?
At my work last week, we hosted some children from a local school for an inspiration day. The kids, in this instance ranging from 14-16 years old, came in for a morning and sat through a variety of talks, presentations and fun games from different members of my company, designed to inform them about what we do as a firm but also to generally inspire and motivate them to keep working hard in school.
I was tasked with explaining the need to save for a pension and the power of compounding. It is a talk I have given a few times in these scenarios and it is always fun to see young people show an interest in personal finance.
When explaining some of the ideas below, my colleagues in the office, all financially savvy in their own right, were not surprised at the results, but the young adults in the room were blown away. If you already work in the pensions or investment industry you too may not learn anything new here, but for anyone else, I hope some of these basic tips strike a chord somewhere.
Our specimen for this example is James. James starts work at the age of 20 on a respectable starting salary of £25,000 per year. As his career progresses over time, he manages to get an average salary hike of 3% per year – just enough to keep his nose in front of inflation. How much pension does James save up over his working life? Well, that very much depends on James’s decisions over time.
Let’s assume that James only plans to start saving once he reaches 30. Prior to that of course, James will have been busy enjoying his 20’s (I remember those days!) When the reality of planning for the future finally dawns on him, he plans on setting aside 5% of his salary every year into a fund that is expected to earn him 5% per year. Sounds pretty reasonable right?
In return, he’ll pay the investment manager of this fund some fees to the tune of 0.75% per year. With all this set up and running along nicely, James marks out his retirement age of 65, by which point he reckons his salary will have grown to around £90,000 per year.
Based on his projections, James expects to have amassed a retirement pot of £221,000 at retirement. James also expects he’ll live to around 90 years of age. So, he figures that retiring at 65 he will need his pension to see him through 35 years of retirement and he estimates that his pot will provide him with the equivalent of £8,000 per year. That’s around 9% of his final salary.
There are of course some things James can’t control. He can’t magically get a better return on his investments without potentially assuming higher risks and possibly higher fees. He also just can’t ask for a higher salary whenever he feels like it. He also can’t change how long he lives for. That being said, there are a few things he can change, which can have quite a dramatic impact.
1. Start Saving Earlier
It may sound completely obvious, but if James starts saving at 25 or even 20 then his expected retirement fund and pensionable income increase meaningfully. Of course, this may not always be possible nor necessarily realistic. Young people in their 20’s may not have the means to save more sooner. They may be dealing with student debts or assuming other borrowings to help them get started in life (deposits for a flat, car loans etc) or that boozy holiday in Tenerife 😉
But, a big part of the FIRE movement (for me at least) is to influence the younger generation and change the money habits they might otherwise assume by default on account of our generation and those before. When I started to run through these examples with my young audience they were certainly inspired.
All I’m just saying is that this alone can make a huge difference! I don’t think I really knew what a pension was until my late 20’s or probably cared that much in all honesty. But if someone had sat me down and shown me what I know now, that would have been a very different story.
Back to the point and exactly how much of a difference can simply starting to save earlier in life really make? The table below, and those that follow after, provide two scenarios; one showing the effects of a smaller adjustment and another showing the impact of a larger change.
So, had James started at 25, it would have meant saving for another 40 years rather than 35 – i.e. saving about 14% longer. But the pension pot becomes 18% larger in the process. And if he had started at age 20 then, of course, the difference is even better – saving for 10 years more but seeing a pension increase of nearly 40%!
2. Retire Later
Next and with life expectancy creeping ever higher the idea of retiring at 65 is increasingly an outdated concept. State pension ages are already increasing and will continue to do so over time. So, what if James chose to extend his working life and retire a few years later instead? Again, let’s look at both the effects of a smaller change and a bigger one.
By retiring later, James not only has more years to save but his pension fund also gets a few more years of compounding. He will also have fewer years in retirement to fund, meaning that the drawdown on his pot may be less with maybe even something to pass on to family when he dies. Now, the idea of working longer may not appeal to most, but even retiring a year later can make a material difference. A few years more and it’s quite remarkable.
3. Pay More
If you recall, James decided to save 5% of his salary each year. But could it have been 6% instead? Although 6% would represent a 20% increase in what he’s currently saving, it’s just over a 1% reduction in his take-home pay. Is a 1% reduction in his take-home pay a cost worth paying? What difference might it make?
Again, I accept this may not be possible (or desirable) for some. But you only get out of it what you put in!
4. Annual Nudges
An idea I personally try and adopt each year is to nudge up the contributions to my pension every year, even by a small margin. Paying gradually more and more each year is hardly noticeable in the grand scheme of things and a great habit to develop.
Interestingly, James’s contributions at just 0.1% per year mean that by age 40 he’s paying a full 6% a year, and by age 60 he’s paying 8% per year.
What’s more, if annual increases are timed to coincide with pay rises then the take-home pay never has to actually decrease!
5. Reduce Management Fees
Transparency around fees has become the norm in recent years and remaining mindful of the true impact of fees over time and shopping around for the best options every now and again can reduce the total fees that James, and you, will pay. If you recall, James is paying 0.75% in our scenario, but what if he could pay less, which is certainly very achievable in today’s market?
As defined contribution values increase, the ability of managers to operate at lower charges should also increase, making it important to keep an eye on those fees and charges every few years.
6. Get the Company to Pay more
With auto-enrolment now a good few years in, James’s employer (like yours perhaps) has been obliged to pay towards his retirement. So rather than just pay his own way, James should make sure that he is getting the most from any employer contributions. Although the minimum contribution from a company here in the U.K. is around 3% many firms offer considerably more – either through a higher contribution or via matching.
This one is a biggie!
Of course, this does not translate to those of you that are self-employed. But it still works for a very large majority of working folk.
7. Do more than one of the above
The charts show the percentage increases James may have experienced in his pension fund for implementing each of the tips above. These are sorted from the biggest impact to the smallest. In each case, the light green bar represents making the smaller of the two changes, and the dark green bar shows the impact of the larger change.
Applying these tips in combinations can have very powerful impacts on your retirement. My last table below shows the amount James might expect from his pension if he did none of the above as well as what he might expect if he did all of the above – again, first showing the impact of the smaller change, followed by the larger change.
With all the above changes made, by the time James retires his pension pot is expected to be almost 7 times larger, and the amount of money he will be expected to receive as a pensionable income is expected to be 8.5 times larger. As a percentage of his final salary, his pension has grown from 8.9% to 68%.
While all hypothetical by way of illustration, these are all strategies anyone can follow to differing degrees. You also don’t have to be young to feel the benefits. You can do a number of these at any age. All of which goes to show that relatively small changes to the pension inputs can yield much larger benefits when it comes time to retire.
I hope you enjoyed these ideas.
Until the next time