WHAT does a decent pension cost? The short answer is a lot; and a lot more than most people think or want to know.
The government plans to prevent a pensions crisis with two main policies: first, a state pension payable from the age of 67 or 68 of about £7,000 a year; secondly, it is requiring employers to put employees into a pension scheme and pay in a minimum level of savings. This is auto-enrolment. Currently, a total of 2 per cent must be contributed on all income above £5,668 a year. By 2018, that will increase to 8 per cent.
A recent report by Policy Exchange, however, suggested that, for someone on an average income, this would need to rise to 12 per cent to pay for an income of £16,200 a year in retirement. But even this could be too low. If you want to retire today at 65, and secure an annual pension of £9,000 that will keep pace with prices, you’ll need a pension fund of £270,000. Someone earning £29,000 a year and saving 12 per cent of pay above £5,668 will only get such a fund after 40 years if their investments deliver a 4 per cent per annum return over inflation – after all costs and charges.
Historical data suggests that this is possible if you invest well in equities. But it is far from guaranteed. The risk-free investment return is currently about zero above inflation. If you don’t pick your investments wisely or aren’t willing to take investment risk, the numbers change dramatically.
On my calculations, (and not assuming 4 per cent annual returns over inflation) someone on £29,000 needs to save 29 per cent of pay – not 12 per cent – over £5,668 for 40 years to retire at 65. At 12 per cent, someone earning £29,000 a year is looking at saving for 49 years and retirement at 74.
The higher your pay, the less significant the state pension is to your needs and the more you are expected to save. Someone earning £60,000 who wants £30,000 a year in retirement might find themselves working until 78 at a 12 per cent savings rates with zero real returns. If you did earn 4 per cent over inflation, however, retirement at age 66 is achievable on a £30,000 pension.
The message is clear. Save what you can, when you can. Don’t underestimate how much you need to retire when you want, on the income you need. Ensure you keep a close eye on your investments. Employers are increasingly enabling people to save, but they do not want responsibility for monitoring the outcomes. You need to keep costs down, but it is more important to have access to investments that are likely to perform for you. The more you earn, the more important it is that you take an interest in your pension.
There may also need to be a policy change. A better approach to retirement saving would be to encourage the deferral of the state pension until later in life, when it can more appropriately meet your needs. Currently, the state pension rises by 10 per cent every year you defer. You could then use pension or Isa savings to fund the period between stopping work and taking state pension, avoiding the need to buy an expensive lifetime annuity.
But the government does not allow pension funds to be exhausted over a fixed period, and it is about to reduce the rate at which the state pension rises when deferred from 10 per cent a year to 5. It should think again.
Alan Higham is retirement director at Fidelity.