The most common way to save for retirement is with a pension, but even with auto-enrolment, the majority of us are still not saving enough.
In 2018, the Pensions and Lifetime Savings Association (PLSA) published research showing 80% of us are not confident that we are saving “enough” for retirement.
But just how much is enough? And how much should you try to save to have a comfortable retirement? To answer that, we first need to look at the different pension types available to you, and how they might impact your retirement savings strategy.
In addition to the government State Pension, there are a few different types of pension that generally fall into two main categories:
Defined contribution – established by the amount you’ve gradually paid into your pension pot during your working life
Defined benefit – based on your final salary or your career average and the length of time you have been with your employer
To complicate matters, there are further sub-types within each of these.
With these schemes, the pension provider invests the money you have paid in. This means how much you get when you retire depends on the performance of these investments as well as how much you have contributed and for how long.
The government first introduced auto-enrolment in 2012. It rules that all employers must enrol workers aged 22+ who earn more than £10,000 per year into an occupational or workplace pension.
You can opt out if you want, but you would essentially be missing out on free money and government tax relief.
You may have already had a pension through your employer before auto-enrolment was introduced, in which case you would not need to be auto-enrolled into a scheme.
Workplace pensions can also be defined benefit pensions explained below, although these are becoming less common.
If you are unsure exactly what your employer offers, speak to the HR department. You could always get an additional personal pension if you’re dissatisfied with what they offer.
Set up by individuals rather than companies, private pensions are often used by, but are not limited to, the self-employed.
Like other types of money purchase plan, they too attract tax relief up to the annual limits – for the 2019/2020 tax year, it’s up to the lesser of £40,000 or 100% of your earnings.
At retirement, up to 25% of the total pension pot can be taken as a tax-free lump sum and the remainder can be used to buy an income for life, usually in the form of an annuity.
Small self-administered scheme (SSAS)
Self-invested personal pension (SIPP), and Group self-invested personal pension (GSIPP)
Defined benefit schemes pay out your pension as a percentage of your final or average salary, factoring in how long you have been with your employer and your age.
Unlike defined contribution schemes, no money has been invested so the amount cannot go down if an investment has underperformed.
It is primarily your employer who contributes to it – though you can too – and it is down to them to guarantee there is enough for you to live on after retirement.
This type of pension has become far less common than it used to be and is most prevalent in the public sector.
The basic calculation of the amount you’ll need is two-thirds of your previous annual income. This method assumes you’ll need less than when you were working because you will not have a mortgage or rental costs.
Of course, if you still have these payments to make, you’ll need a higher retirement income.
Last year (2018), pension provider Royal London outlined how much retirement income the average UK wage-earner needs per year:
Average UK salary (as of January 2018) = £26,278
Target income in retirement (2/3rds of above) = £17,519
Minus full State Pension of £8,546
Equals target annual income from private or workplace pension = £8,973
While these calculations show the average amount you’ll need (provided you’ve paid off your mortgage and do not pay rent), exactly how much you personally require depends on the kind of life you want and expect when you retire: simple or lavish?
The Money Advice Service has an online calculator to help you work out how much retirement income you’ll need.
In 2018, research by social change charity, The Joseph Rowntree Foundation, found that for basic retirement, a single person needs around £11,100 per year.
This covers essential living costs and includes a week’s holiday in the UK, alcohol, cinema visits, mobile phones and internet access and assumes the person has no mortgage or rental costs.
If you think you will want to participate in more activities than the basic amount allows, you’ll need to increase that figure. Standard Life has a useful interactive tool to illustrate this.
Consumer group Which? found its members needed on average £26,000 per year, per household. In addition to basic costs, this covers extras like a two-week holiday in Europe, regular meals out and hobbies.
According to the same research, a luxurious retirement that includes long-haul holidays and changing your car every five years, requires around £39,000 per year.
In general, a single person needs about two-thirds of the amount a couple needs. This is because some costs such as heating, insurance and the costs of running a car are the same for one person as they are for two.
How much money you need to save per month depends on when you actually start saving and how much you want to save in total.
The earlier you (and potentially your employer if they match your contributions) start adding to your pension pot, the less you will need to save each month because the cost is spread over a longer period.
Moreover, if you start saving early, your funds will accrue the extra benefit of compound interest throughout the duration of your savings. Making money from the interest means you can actively save less and still end up with the same amount.
Compound interest works like this: if you put £2,000 into your pension per year (roughly £166 per month), and the growth rate of the pension is (a conservative) 5%, you will earn £100 in interest. That amount gets added to your pension pot so you’ll have a total of £2,100 at the end of year one.
The following year, you’ll earn 5% interest on £2,100 plus the £2,000 you pay in during that year, giving you £205 in interest. Your total at the end of year two would be £4,305 (£2,100 + £2,000 + £205), even though you’d only put in £4,000.
If you follow this logic year after year, compound interest really starts to kick in. After 10 years, your net contribution would be £20,000, but your pension pot will be worth around £29,000.
After that, assuming you keep contributing the same amount and the interest rate stays the same, your pension will roughly double every 10 years.
So you can see you could potentially keep the monthly amount you save the same for the duration of your pension or indeed your working life (if you change jobs and get a different pension with your new employer) and earn a decent amount by the time you retire.
Bought with your pension fund, an annuity is an insurance product that provides a regular income for life. More costly than they once were (because of low interest rates and rising life expectancy), they still remain a good option for many.
The current average annuity offers a 3.56% interest rate. In order to get the target annual income of £9,060 when you retire, you’d need to buy an annuity worth £260,000.
You would be able to do this if you first started saving £2,000 per year when you were 25 years old. By the time you are 65 years old, your pension pot would be around £250,000 – assuming a 5% growth rate per year.
Your pension income is usually made up of income from a private (and/or company) pension alongside your State Pension. It can be supplemented by savings income, part-time work or other sources of income like investments.
In 2015, the government introduced new rules about accessing retirement savings.
The new rules provide greater access and more options as to what you can do with your pension pot:
You can take out the whole pension amount when you are 55
There is no tax on the first 25%
The rest is taxed as if it was a salary at normal rates
Generally, it’s not a good idea to withdraw money at 55. This is because many people are still in the process of saving what they need for a comfortable long-term retirement. The sooner you withdraw the money, the less interest you will earn on it.
There are six main options here:
Keep the pension pot as-is and live of other sources of income
Buy an annuity
Get an adjustable income (Flexi-Access Drawdown)
Take cash in chunks (Uncrystallised Funds Pension Lump Sum)
Cash in the whole pot in one lump sum – remember only 25% of it will be tax-free
Mix and match any of the above
Pensions are a complex financial product – but they’re also a very important way to ensure your long-term financial security.
If you have more questions, it might be worth talking to an independent financial adviser to find the right pension strategy for you. The Pensions Advisory Service offers free advice by phone and email.