Pensions are difficult even to the experts, but they can be simplified.
Part of the complexity is the experts themselves. The basic pension mechanics are straightforward arithmetic, which although boring can be carried out on a simple spreadsheet.
However like mortgages you do not have to know or understand the details but just the results.
The main questions that one needs to ask are:-
· How much do I need to save and for how long to get a reasonable retirement income?
· Can I afford it? And what about State Pension?
· What will be a reasonable income when I retire? What about inflation?
· How secure are my Pension Savings
· Are they worthwhile, will they give good value for money
Pension contributions accumulate year by year; if properly managed these savings also grow on a compound interest basis, so the longer you save the better and you can never start too early.
The timescale is long, 40 to 50 years, and in this rapidly changing world, a lot can happen in this time.
The need to look after oneself however does not change and all at some time feel the urge to put something away for a rainy day. This is never more important than in pensions for retirement.
The amount one needs to save can be simply expressed by a Pension Yield Factor linking total percentage contributions to pension income required in either real or final salary terms for number of years saved. Although dependent on many external factors, these can be specified and reasonable values taken.
If wages and growth of the accumulated fund keep up with inflation/ living costs, the real term position is that over forty years, at 10% total contributions, you will have saved four times your annual salary, which if drawn at a 6% income will give a pension of 24% final real salary; a factor 2.4 up on contributions.
This is the least target that pensions should aim for. Wage increases are usually above inflation, on average 3%; annual Fund growth should be some 6%, (some schemes take 8% as a basic aim). 6% growth increases this factor to 5.7 in real terms. Of course tax free sums require extra savings of a third higher.
The PYF, assuming inflation at 2.5% and wage growth at 3%, and payment/ annuity/ drawdown at 6% is:-
Years of contributions 10 20 30 40
Fund growth 3% 0.64 1.34 2.11 2.96
Fund Growth 4% 0.67 1.38 2.46 3.64
Fund growth 6% 0.74 1.83 3.42 5.72
Fund Growth 8% 0.82 2.29 4.9 9.4
The factors derive from compound growth calculations and show the need for long term saving.
Unfortunately many schemes, particularly Defined Contribution barely keep pace with inflation.
The new NEST scheme aims to give a 15% pension for 8% total contributions, a poor factor of 1.9.
How much pension income is needed depends on the living standard you are used to. A simple way to determine this is from your current earnings, after Tax, NI, Pensions and other deductions, take away mortgage, child and work related costs to arrive at your basic living costs. Generally this will come out at 40% and should be your retirement living costs; 50% of current wage in real terms is a reasonable aim.
This will be continued in the next blog, however apologies for the necessary Arithy bits.
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