Updated 24 January 2018
Saving into your pension is known as the ‘accumulation’ phase. How much you can save up depends on many factors – but you have more control over these than you think. Neil Adams of Drewberry Wealth explains how you should ‘calculate to accumulate’.
Working out how much to put into your pension can be something of a headache. It requires much speculation as to future investment returns, contributions and inflation, as well as some pretty broad guesses about what your future holds – both in terms of your remaining working life and the increasingly long retirement that you can now expect.
This means making some pretty blunt assumptions about your lifespan. Most of us tend to be pessimistic about our lifespans but over-optimistic about investment returns – which creates an obvious problem when it comes to retirement planning.
You can get a better idea of your likely innings by using a life expectancy calculator. As for investment returns, that can be a little more complicated and hard to predict.
Although pension rules have changed a lot lately, some things remain the same. Thanks to the power of compounding, the best way to build a decent-sized pension pot has always been to start early. So don’t make the most expensive mistake that a pension saver can make – putting off funding a pension until you’re closer to retirement. As the chart below illustrates, the cost of deferring contributions to a pension is simply harrowing.
This chart assumes a basic-rate taxpayer who invests a flat £250 a month along with the tax relief they receive, into a pension fund that delivers 6 per cent annual compound growth until they reach 65. So we can see that the saver who started her pension at age 25 would have a pot worth some £622,340 by the time they reached 65. But the person who starts just 10 years later would achieve only half the size of pension pot – that short delay would cost him almost £309,000! Meanwhile, the person who waits until the age of 45 would have around 77 per cent less in their final pension pot… and so on.
That’s the effect of compounding. The percentage losses are much the same for a higher-rate taxpayer, although – thanks to the additional tax relief on offer – the total pot after 40 years would be an impressive £830,000.
Short of winning the Lottery or receiving a similar windfall, few of us will ever be able to make up for lost time when it comes to pension saving. So the best strategy is always to contribute as much as you can afford, as soon as you can, and to increase your contributions whenever circumstances allow.
You can invest lump sums into a personal pension alongside your regular contributions, so long as you don’t exceed your annual allowance each year. For many of us, this will be £40,000 (or your annual salary if it’s lower). You can also ‘super charge’ your pension with significant lump sums that mop up any of your unused annual allowance from the last three years, using what’s called ‘carry forward’.
To illustrate this, we calculated the additional boost that a pension pot would receive if a basic-rate taxpayer contributed a full year’s ISA allowance of £20,000 to their pension as a single lump sum (using the same 6 per cent pa compound return and tax relief assumptions).
After 20 years, this single investment would be worth £80,000 – while over 30 years it would have added well over £143,000 to the investor’s pension pot. The same figures for a higher-rate taxpayer would be almost £107,000 after 20 years and over £191,000 after 30 years.
This exercise also underlines how the contributions you make early in your working life will be worth far more than those you make later – even though the latter are likely to be far larger.
The final part of the puzzle when getting to grips with your future pension pot is to understand that the race doesn’t end when you reach your target retirement date. To prepare for retirement in this country, most of us will need to calculate how long our pension pot will last us once we start to rely upon it. This is because the recent era of super-low interest rates has effectively ended the usefulness of the traditional annuity.
Once upon a time, when Brits reached retirement they generally took a 25 per cent tax-free cash sum, and used the rest of their pot to buy an annuity – a fixed income for life that could (for additional costs) be index-linked or include a widow’s pension. But the world has moved on since then.
Among other things, UK annuity rates have crashed to their lowest levels in over 300 years, making it unlikely than any young retiree in good health would consider an annuity as their first port of call. These days, a £100,000 pension pot would buy a 65 year-old a ‘single life’ annuity that pays an income of just £2,5701 a year. What’s more, the income from this would cease the minute the buyer died – regardless of when they bought it. You would have to live to be well over 100 to make this good value.
Fortunately, we now have pension freedom, which offers retirees far more choice.
‘Flexi-access drawdown’ (or just ‘drawdown’) will be far more useful for most of the UK’s coming crop of retirees. This allows you to keep your pension pot invested throughout your retirement and take income or lump sums as you need them, subject to tax rules. The downside is that you bear the investment risks yourself, along with the risk that you could run out of money if you fail to manage your withdrawals properly.
So besides calculating how much your pension pot will be worth after your ‘accumulation’ years, you should also work out how long it could last in the ‘decumulation’ phase – the unknown period of time after you begin to draw your pension.
This might sound like a lot of number crunching. But we can save you the trouble. Drewberry’s new Pension Pot Calculator can not only help you work out how big a pension pot you can accumulate – it can also project how long that pot is likely to last in your decumulation phase.
Yes, saving into a pension is complex. But never let that put you off. Because the tax relief on offer is the most valuable benefit you’ll ever receive in the long term, and the single best way to build up a fund that can last the length of your retirement.
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1 Based on open market annuity rates available as at 23 May 2017.
Neil Adams is head of pension planning at Drewberry Wealth Management.