How Much Should I Save For My Retirement?

bigbloke45 · 29 April 2008 at 4:58PM

This is the BIG Question.

Until this has been answered, the rest is Conversation.There must be lots of MSE's out there with Spreadsheets designed to Model what needs to be done now to secure a decent future. I have some and some ideas to keep it simple.

But, as a start, have alook at this one http://www.citywire.co.uk/personal/retirement/do-i-have-enough-to-retire.aspx. I think it makes a start; but I think we need a model that allows us to change the assumptions to suit ourselves.

rathga · 29 April 2008 at 5:34PM

The way I have looked at this is as follows.

Your four simple variables are:

Desired Income: What you want your annual income to be when you retire (in today's money)
YTR: The number of years between now and when you plan to retire (i.e. 25 if you're 30 and want to retire at 55)
Inflation: what you expect average annual inflation to be over this time
Annuity Rate: Assumed 'inflation proof' annuity rate when you retire (i.e. the rate on an annuity that keeps your annual pension constant in real terms)

Firstly you work out what your future annual income would be by applying YTR years of inflation.

Future Desired Income = Desired Income * (1 + Inflation)^(YTR)

Then, very roughly:

Future Desired Income = Pension Pot * Annuity rate

And therefore:

Required Pension Pot = Future Desired Income / Annuity rate

Which will give you what your pension pot amount must be at the time when you retire.

If your 'years to retirement' is long, this number will seem ludicrously high as you have lots of inflation built in. It's worth remembering your salary and pension funds should (hopefully on average) also grow at least with inflation.

So for example, for myself:

Desired Income = £35,000
YTR = 55 - 24 = 31 (I'm 24 wanting to retire at 55)
Inflation: 3% (pure assumption)
Annuity Rate: 3.5% (pure assumption)

Future Desired Income = 35,000 * (1.03)^31 = £87,502.81

Pension Pot = 87,502.81 / 0.035 = £2,500,080

This is purely your 'private' pension and ignores any state pension etc. you may receive (you should adjust the 'desired income' appropriately. You can change your inflation/annuity assumptions to make optimistic/conservative scenarios. Once you have this number you can model what contributions you need to make over time in order to achieve it, and then see how realistic your Desired Income is, etc.

Would be happy to hear people's thoughts!

fimonkey · 29 April 2008 at 6:48PM

Wow Rathga, that sound complicated (for a dunce like me) but very useful.

How can you use your equation to calculate how much one should save each month into the pot (also taking into account employer contributions).

So for instance, say I am about to take out a stakeholder, to which my employer will contribute 5% of my slary of 31Kpa Gross.

I am 30 years old and want to retire aged 65.

I want to retire on an equivalent of 20K (net, so after tax if tax is paid on pension payments?). in todays terms.

How much do I need to contribute to my stakeholder now and will this amount be fixed for the rest of my life, or increase yearly?

Hope that makes sense, I'm incredibly green with all of this and just finding my feet a bit, but have no head for figures at all unfortunately.

CLAPTON · 29 April 2008 at 7:05PM

my view is that its better to work in current values and not to add inflation as rathga has, because you have also to add inflation to your pension savings which makes its all too unreal.

gibbyni · 29 April 2008 at 10:55PM

try out this calculator http://www.h-l.co.uk/pensions_and_retirement/pension_calculator.hl

purch · 30 April 2008 at 8:17AM

Pension Pot = 87,502.81 / 0.035 = £2,500,080

To get a Pension Pot of £ 2.5 bars in 31 years

£2,000 a month I would guess

rathga · 30 April 2008 at 9:41AM

fimonkey wrote: »

Wow Rathga, that sound complicated (for a dunce like me) but very useful.

How can you use your equation to calculate how much one should save each month into the pot (also taking into account employer contributions).

So for instance, say I am about to take out a stakeholder, to which my employer will contribute 5% of my slary of 31Kpa Gross.

I am 30 years old and want to retire aged 65.

I want to retire on an equivalent of 20K (net, so after tax if tax is paid on pension payments?). in todays terms.

How much do I need to contribute to my stakeholder now and will this amount be fixed for the rest of my life, or increase yearly?

Hope that makes sense, I'm incredibly green with all of this and just finding my feet a bit, but have no head for figures at all unfortunately.

This is where your model can get more complex (if you want it to!). You can use spreadsheets or models or just a few equations, depending on what your circumstances are and how many variables you want to incorporate.

If you just want a quick estimate based on what you have mentinoed above, you could consider the following. First, work out how much cash you need in your pension pot when you retire.

From the above:

Desired Income = £25,000 (let's assume you have a 20% tax rate in retirement bringing your net pay to £20k - in practice the tax will be slightly less as you have your personal allowance)
YTR = 65-30 = 35
Inflation = 3% (pure assumption)
Annuity rate = 3.5% (pure assumption)

Future desired income = 25,000 * 1.03^35 = £70,347

Required Pension Pot = £70,347 / 0.035 = £2,009,902

Once you have this number you know how much you need to achieve. There are immunerable ways you can potentially get to this amount over your 35 years (employer contributions over time, additional AVCs, more cash in the early years, escalating payments, fixed payments, lottery winnings etc. etc.). It is probably best to start with the simplest, cheapest way you can think of and seeing if that is sufficient. If it looks like it won't be enough then you can consider what steps you need to take to make up the shortfall (AVCs, higher payments, selling family members, etc.).

So you could start by working out how much your stakeholder will be worth in 35 years time, assuming your employer just puts in the fixed payment of 5% gross salary per year. For this you need to assume:

Wage Growth: The annual appreciation of your salary
Interest: The annual appreciation of your retirement funds

Then you just use a growing annuity formula (which may look a bit complicated if this is the first time you've seen one). (This calculates the future value of a series of payments that are growing over time (i.e. your contributions will grow by your wage growth) and are compounded at a certain interest rate (the interest on your pension funds). See http://en.wikipedia.org/wiki/Time_value_of_money#Future_value_of_a_growing_annuity if your interested):

Future Value of Stakeholder = Current Gross Salary * Contribution Percentage * ((1 + Interest)^YTR - (1 + Wage Growth)^YTR) / (Interest - Wage Growth)

So assuming your wage growth is (on average over the 35 years) 4% per year and the average interest on your pension funds is (again on average) 7% per year (both pure assumptions):

Future Value of Stakeholder = 31,000 * 0.05 * ((1.07)^35 - (1.04)^35) / (0.07-0.04) = £347,742

So, based purely on the assumptions (inflation, annuity rate at retirement, wage growth, interest on pension funds) when you are 65 you will have a shortfall of £2,009,902 - £347,742 = £1,662,160 if you rely on your employer stakeholder contributions alone.

So your next question might be: How much in annual additional contributions do I need to make to hit my target?

This can be answered by reversing the growing annuity formula to solve for the required contribution amount.

Required Annual Contribution = Pot Shortfall / (((1 + Interest)^YTR - (1 + Inflation)^YTR) / (Interest - Inflation))

So, the required annual contribution to make up your shortfall of £1,662,160 would be:

Required Annual Contribution = £1,662,160 / ((1.07^35 - 1.03^35) / (0.07-0.03)) = £8,456

This annual contribution is in today's money, so you will need to increase it by inflation every year (i.e. if inflation is 3%, next year you would need to contribute 8,456*1.03 = £8,790, and so on). Also bare in mind that this is a gross figure after tax relief. If you pay basic rate tax then you need to contribute only £8,465 * 0.8 = £6,765 of your net salary each year.

This may seem like a lot, but bare in mind that its based purely on the assumptions above. It's worth building a little spreadsheet and playing around with these. For example, you may expect your wage growth to be a little more or annuity rates to be a little higher, etc.

The above also assumes that you make regular annual payments over the 35 years, which may not be the most efficient strategy as earlier contributions count for a lot more than later ones. To the extent you can make big contributions early in the life of your pension there is more time for compound interest to do its work and you may be able to reduce the overall amount you need to contribute from your salary.

Hope this somewhat helpful. If not, there are lots of other approaches and calculators you can try.

EdInvestor · 30 April 2008 at 1:06PM

fimonkey wrote: »

How can you use your equation to calculate how much one should save each month into the pot (also taking into account employer contributions).

I want to retire on an equivalent of 20K (net, so after tax if tax is paid on pension payments?). in todays terms.

You'd be wise to check out what you can expect from your state pension first (after October when they have updated the computer for all the post 2010 changes).

Many people retiring now who have been contracted in for their working lives on average salaries will be getting 2 state pensions worth around 10k. This would be equivalent to a savings pot of around 400k because of the valuable index-linking and spouse benefits.

You may find the task is not quite as daunting as it looks.:)

Retired_I.F.A. · 30 April 2008 at 1:23PM

The problem with most of the calculators is that they assume level payments, and those that assume escalating ones are usually the ones where the variables are those described by the regulators and they are usually produced using life office specific charges.

I wrote a few such spreadsheets that IMO do a "proper job" on a psion palmtop about 9 years ago and might still have them if I spend some time re learning how to use the psion as I still have it's files backed up on my pc but there again what I have backed up may be an earlier save.

The other factor no one here is considering is interest rates at the retirement date. The great bit about inputting your own variables is that you can answer many "what if" questions so for instance if you want to know the effects of say a constant rate of 10% for inflation and contribution escalating at 12% for 30 years it's going to be way off reality if you use a current annuity rate of say 6% as it's underlying interest rate (gilts) is 4.7% or so.

Even then you may be looking at a single life annuity so ideally you need a spreadsheet that will allow the input by you of the annuity choices single life, guaranteed period ,spouses proportion etc and to include those requires mortality tables to be incorporated in the spreadsheet.

I know I wrote the perfect spreadsheet that did it all, hell it took me 6 months of spending 3 or 4 hours a night on the psion but it was worth it for me as an IFA just to answer clients what if questions when reviewing their plans. It eventually ended up with a version which calculated the critical yield required in order to match retained benefits when transferring to a personal pension and was so accurate on a couple of occasions I used it to prove some of the insurance companies transfer value analaysis reports to which the jest was these calculations were off somewhere or other.

The actuary who gave me the mortality tables said he doubted it could be done on a spreadsheet and was surprised so much when I showed him the results of 6 months of dossing on the settee till 3 am every night he spent the next 20 mins or so trying to convince this then 40 year old ought to train as an actuary. I wish he had suggested it when I left school with my cse maths certificate

rathga · 30 April 2008 at 2:11PM

Retired_I.F.A. wrote: »

The other factor no one here is considering is interest rates at the retirement date.

It's the fourth variable in my first post! Pah.

Arguably there's no point modelling this value as ultimately you're always speculating on what gilt yields will be in 30 years time, which is pointless. My approach would be to just assume it is conservatively low (i.e. 3.5% compared to approx. 6% today) using today's rates as a guide. Of course you also need to consider this in the context of how conservative/optimistic you have been on your other assumptions.

Retired_I.F.A. · 30 April 2008 at 2:30PM

The current gilt rate for 15y gilts is 4.75% add mortality and the type of annuity and you'll come up with say 6% or so for single no g-tee no spouses proportion annuity rate and say half that for all the frills. If in a speadsheet your allowing the user to input his own assumption for interest and inflation it is essential that motality tables are included and the underlying gilt yield to be added as another variable input. Otherwise the whole point of having a calculator which allows you to see the effects of different future assumptions is pointless.

How Much Should I Save For My Retirement?

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