Few words can stop a conversation as quickly as “retirement”. Many of us can hardly bear to think about it, never mind talk about it. Others – just under half, according to our latest Investor Pulse survey – do save for old age, but with no confidence we’ll get the income we want at the end of it.
Whatever the case, one thing is clear: few of us are keen to talk about our retirement or pension.
So what? After all, when many of us started our careers, employers had to provide retirement income, not employees. But due in part to significant gains in life expectancy, these final salary schemes are disappearing – and the defined contribution schemes that replace them shift the burden firmly onto workers.
To make things worse, Investor Pulse also revealed what Britons like to do rather than put money into their pension: hold cash, the lowest-returning asset class. Around two-thirds of the average British portfolio is in cash.
This mix of disengagement, less generous pensions, greater personal responsibility, longer lives and a love of cash means many Brits who don’t prepare now are sleepwalking into an insecure old age. Is it any surprise that people don’t want to talk about it?
But it doesn’t have to be like this. We live in an era of unprecedented financial freedom. And to help people feel more positive about retirement, we need a radically new discussion of what it actually means to retire.
Let’s change how we think about retirement
When the state pension was conceived in 1909, it promised two to five shillings per week for men aged above 70. But average life expectancy was around 50 – the equivalent of offering a pension now at 129 years old.
Today our retirement system is very similar. You work and then, on a specified date, you stop. But this doesn’t match up to modern lifestyles, where many people are healthy long past their 60s, want a period of semi-retirement, or perhaps intend to pack it in before their set date.
So the first thing we need for retirement in the twenty-first century is an arrangement that is more flexible. If you want to stop working earlier or later, that is your choice.
Second, we need something that puts the power in your hands. Rather than waiting for retirement to “happen”, we need a system where you set the rules. The name for this “rebooted retirement” is “salary independence”.
Salary independence is based on a simple but powerful concept. Rather than thinking of being a worker and then a retiree, instead you are “salary dependent” and then “salary independent”.
The former means what it says – you are dependent on your salary to support yourself. The latter is the state you reach when you no longer need to rely on your salary to live – when the assets you have built up can support the lifestyle you want. Let me explain how it works.
Step 1: Forget about the size of your pot
The first step towards salary independence is to stop thinking about the size of your pension pot. Rather, think about how much income you could survive on happily if you didn’t have to work. Would £18,000 cover it? That’s £1,500 per month before tax.
This figure really matters, so it’s important to get it right. When you earn enough from your investments to cover that amount, you’re free to stop working or to continue if you like.
Step 2: Make your plan
Once you’ve decided how much income you need to live happily, it’s time to figure out how to achieve it.
We’re developing a tool to help you plan for salary independence – but until it’s ready, there are a few simple calculations you can do for yourself.
First, take your salary independence income target (for example £20,000) and divide it by 0.04. This is roughly how much you’ll need to achieve salary independence – in this instance, £500,000.
Next, decide a monthly savings goal. It’s important to be ambitious. The more you save, the faster you reach your goals. Twenty per cent of your salary is a demanding target but would yield impressive results if you achieved it.
Now it’s all about how long it takes to hit your goal. Because this involves compound interest, it’s a bit trickier to calculate – but there are plenty of sites online where you can put in that monthly savings target, and expected growth, to see how many years it would take.
It also matters how you save. By investing in a fund, you might see 5 per cent growth a year, while a cash savings account might offer only 1.5 per cent. So if 20 per cent of your salary is not feasible – and for many it isn’t – you could consider putting your money to better use by investing it.
Once you have an income goal, a monthly savings goal, and your predicted salary independence date, you can focus on how to make it happen.
Step 3: Pick an approach to make it happen
You’d be forgiven for feeling a bit confused at this point. There’s a dizzying array of ways to save for the long term. However, for the purposes of becoming salary independent, only two really matter, because they are the most tax-efficient ways to save.
The pension (workplace and personal)
The major advantage of a pension is that you can put money in with tax relief. Higher rate taxpayers, for example, have every 60p topped up to £1 under the current rules. In return for tax relief on the way in, you get taxed at the end, whether you want to draw an income or take your pot out as cash.
Previously you had to turn your pot into a lifetime income (“annuitise”), but thanks to pensions freedom, you no longer need to – you can take it out as you wish from the minimum retirement age, currently 55. The first 25 per cent can currently be taken tax-free.
An Isa doesn’t give you tax relief on the way in. Someone on £40,000 per year has to earn £1.32 before tax and National Insurance for each £1 they put into their Isa.
At first glance that seems much worse. But an Isa has advantages of its own. To start with, you can take your money whenever you want. Compare that to the restrictions imposed on pensions. The minimum retirement age is 55, rising to 57 by 2028 and very probably further beyond that.
Second, while you’re taxed on what you put in, anything you take out is free of tax. So if you are a 20 per cent taxpayer now, but expect to be a higher or additional rate taxpayer in the future, it might make sense to put in your taxed money now to take a “free” income in the future.
Third, unlike pensions, Isas have not become a political football. This might change in the future. But based on the past, an Isa might be preferable if you don’t like the idea of your primary long-term savings vehicle being experimented upon.
Invest or save?
One of the best bits of thinking about income rather than pot size is that it helps you consider the best method to achieve your goals.
One option is to save more. In this case, simply up the percentage of your income that you put in each month.
Another option is to save better. This could involve a stocks & shares Isa that you pay into each month alongside your pension. Thanks to compound interest, you don’t need to put masses in to benefit. Our calculations show that investing £2,500 per year (just over £200 per month) for 40 years would give you more than £7,500 annual income for the rest of your life.
By investing your money, rather than leaving it sitting in a current account, you might be able to reach your goals with less input. That would mean more disposable income in your pocket. Other options include working longer and accepting less income in retirement. Neither is that appealing for most people, but the choice is yours.
It’s in your hands
The key to salary independence is freedom – the freedom you have to control all of the variables in your own financial future. You can decide how much to save, how much income you need to live happily, when to access your money, and where to invest it.
By thinking about how much income you will need in your old age, you can recalibrate your priorities. Do you want to work longer to achieve that income? Save more? Invest the spare money in your current account? It’s up to you.
Of course, stopping work as early as possible is not appropriate for everyone. But hard work today can give you that most precious commodity: choice.