I write about three retirement planning tips worth knowing because it is a question I'm often asked by clients, when helping them set up a private pension plan. How much do I contribute to a pension in order to achieve my retirement planning objectives? Or how do I work out the ideal pension pot to save towards? So, let’s discuss it further.
A general rule of thumb often talked about to save towards pensions is half your age as a percentage of contributions to receive two thirds of your final salary. This rule would mean that you save more as you get older and at age 60, you put away 30% while at age 20, you put away 10%.
Not a big fan of this ratio (although it provides a rough starting point), as it ignores the huge benefits of compounding. I believe it makes more sense to front load contributions, to invest more when you are younger, if you can afford to, to use the miraculous power of compounding to make your money work harder. To start sooner, rather than waiting for the ideal amount to contribute. Remember, if you are a tax payer, pensions are highly tax efficient too.
Useful questions : When was the last time you had a good look at all your pension plans? This includes your private pension plans and any work related pension schemes. Do you know the gap between where you are to where you want to be and how to plug this? If you have moved, have you updated your old employer?
The two foxes at retirement that can steal your retirement eggs from your garden, metaphorically speaking, are tax and inflation. They will deplete your income- remember, pensions income is taxed as earned income. Retirement planning tip: So, when you factor in your lifestyle at retirement, remember to factor in these two elements - tax & inflation.
A rough guide to work out the pot required at retirement would be 20 times your current annual expenditure, assuming you are quite far from retirement. A suggested percentage to take income from the pot is at 4%, whilst leaving it invested – so as to grow another 4%, allowing it to combat inflation.
Not all of your income in retirement needs to necessarily come from a retirement plan – but it is useful to work out what is a good level of income you would like in today’s money at your planned retirement age – and then work in some inflation assumptions to work out the likely future value. Then work backwards to work out contributions, with rational assumptions on growth levels of your contributions. The income could come from a variety of sources- pensions, investment income yield from ISA’s, rental income, etc.
Also, remember a pension ( private pension or other) is just a tax efficient investment. It is worth looking under the bonnet annually and reviewing the performance of the funds you are invested in as well as the overall risk.
Spend some time visualising your retirement and how it would look before doing the maths. I find in general we spend very little time thinking about this – with life expectancy rates on the rise, retirement planning is extremely important.
It is also hard to focus on a plan, without a clear vision – I somehow cannot seem to avoid sounding like a motivational guru at this point, I know. On a serious note, some of us would like luxury cruises, travelling and being generally fairly laid back, others may never see themselves ever stopping working, others a more modest, minimalist lifestyle.
Retirement planning tip: It is worth putting chalk to board mentally and really looking at the retirement vision.
I like talking about this example from Richard Russell of the Dow Theory Letters on the power of compounding because I find it inspiring and I love the look on my client’s faces when the penny (pun intended) drops with a big clang. Retirement planning tip: Harness the power of compounding.
The power of compounding is illustrated in the following example:
Miss Jones, lets say, An 18-year-old puts £2,000 into an account each year from the ages of 19-25, then stops contributing and lets it compound at a rate of 10% simple interest until age 65. That means she has contributed only £14,000 in total. Thanks to compounding, by age 65, she’s almost a millionaire, with £944,641 in her account. Remember the 18 year old stopped early.
Now, let’s say another person, Miss B, a 26 year old who starts a few years’ later puts £2,000 per year into her account starting at age 26. Assume the same compounding rates until age 65. Except she contributes £2,000 every single year from ages 26-65, which works out to £80,000 in total… more than five times what the 18 year old had contributed.
By age 65, she’s almost a millionaire, too, with £973,074 in his account.
So, a quick recap, Miss A contributed only £14,000 (£2,000 per year over seven years) and ended up with £944,641. That’s a net gain of £930,641 or 66 times her original investment.
Miss B contributed £80,000 (£2,000 per year over 40 years) and ended up with roughly the same or £973,074. That’s a net gain of £893,074, or 11 times her original investment.
So who do you think made money and time work on their side?
Hmm, no brainer. So the key is to start soon and if you can’t contribute a huge amount, start anyway. Get time on your side!