Pension Planning - Is there a better way?

marathonic

I'm 30 years old and am wondering how people go about planning their retirement. I've read extensively on the subject over the past few years and the following are my thoughts:

• Assuming NO state pension - when auto-enrollment comes in and people retiring have more significant pension pots (on average) than they do now, the government will be better placed to reduce pension benefits. I'm under no illusion that they'll not take advantage of this opportunity which is why I'm assuming no state pension - if it exists, I'll have a more luxurious retirement.
• My mortgage, which should represent around 30% of my income throughout my life (assuming I trade up as my salary increases) will be paid off.
• My medical expenses and expenses associated with keeping myself occupied when I would have normally been working will result in an expenditure increase. The reduced costs associated with work (clothes, travel, etc.) and the fact that I no longer need to make pension contributions will more than cover this.
• Given the above, I'd like to retire on 60% of my pre-retirement salary
• My salary should increase with inflation as should my pension contributions - I'll remove inflation from growth rates to get figures in 'today's money'

For my ideal scenario of retiring at 55, I'd take growth rates of 2.5% for real GDP growth (we should return to this eventually) + 2.5% for inflation + 2% for dividend yield = 7.0% long-term total return.

If growth rates are below this or I happen to reach 55 at the low point of an economic cycle (think 2009-2010), my retirement date would be pushed forward from the ideal age, up to a max age that, for me, I've set at 65.

A current salary of £25,000 would require a pension of £15,000. With a 4% withdrawal rate, this would require a pot of £375,000.

Growth after inflation using the above assumptions would be 4.5%. To get a £375,000 pension pot, for a 30 year old with a £40,000 current pension value would require a monthly contribution of £455.79 (including employer contributions). This is 22% of annual salary.

Obviously, a reduced pension requirement or increased age would reduce this significantly. If you were to aim for a retirement age of 60 instead, given a £40,000 starting pot for a 30 year old, the percentage would reduce to 14% (£291.15 per month).

As you can see, an increased age for your assumptions results in significantly less contributions. However, it leaves less room for adjustments if growth rates are below expectations or you happen to retire at the bottom of an economic cycle (of course, closer to retirement, you should be in less risky asset classes - but that's a different topic).

For my 22% contribution requirement for a 30 year old hoping to retire at 55, this would require a 13% personal contribution with my company - given they contribute 9%.

marathonic

To add to the above, I'll use a hypothetical 22-year old new entrant to the workforce:

• Age: 22
• Salary: £25,000
• Desired retirement income: £15,000
• Desired retirement age: 55
• Employer contribution: 4%
• Growth rate after inflation: 4.5%
• Withdrawal Rate: 4%
• Required pot: £375,000

The above assumptions would require a £413.27 monthly contribution. This would be 20% of annual salary - or 16% personal and 4% company.

I realise these contributions appear crazy but that's purely because the retirement age used is very low.

Linton

One could discuss the details of your figures, but I think your approach is right and is coming up with a realistic figure for the amount you need to put into your pension. For much of my working life me and the company together were putting over 20% of salary into my pension, I retired at 55 + 1 month.

You now have a justification for the pension contribution and a target investment return. You can monitor these on an annual basis and make adjustments as required. When you get closer to retirement you may find it useful to put together an Excel based financial plan based on cash flow each year.

One thing you should consider, purely from a financial point of view. It would seem you are not married: an extra salary provides much more income than the cost of running a spouse

dunstonh

Assuming NO state pension - when auto-enrollment comes in and people retiring have more significant pension pots (on average) than they do now, the government will be better placed to reduce pension benefits. I'm under no illusion that they'll not take advantage of this opportunity which is why I'm assuming no state pension - if it exists, I'll have a more luxurious retirement.

Auto enrolment should reduce the long term hit on benefits. However, its not the state pension that is being targeted. It is means tested benefits. The state pension itself is affordable.

My mortgage, which should represent around 30% of my income throughout my life (assuming I trade up as my salary increases) will be paid off.
My medical expenses and expenses associated with keeping myself occupied when I would have normally been working will result in an expenditure increase. The reduced costs associated with work (clothes, travel, etc.) and the fact that I no longer need to make pension contributions will more than cover this.

Correct. But then you will have 7-8 extra hours a day in which to spend money should you choose to do so. Unless you have low cost hobbies, have some strange desire to watch daytime TV or are happy sitting in a chair drinking tea and watch the world go by.

Growth after inflation using the above assumptions would be 4.5%.

Too high to use for assumptions. You may get it and you hope you would but for forward planning, it is too high.

Withdrawal Rate: 4%

Again, too high for the age of retirement. You need to factor in inflation. An income rate of 2.5% is probably more realistic.

For my 22% contribution requirement for a 30 year old hoping to retire at 55, this would require a 13% personal contribution with my company - given they contribute 9%.

I think that 22% contribution for a 25 year term to be sufficient on income for life is unlikely to be enough.

hugheskevi

All looks about right, but haven't gone through numbers in detail. Main thought is that looking at sensitivity using variant assumptions is important, as frequent recalculations as you age.

Some thoughts about various things in the calculations:

I'm 30 years old and am wondering how people go about planning their retirement.

There is a whole span ranging from reliance on crude rules of thumb, through calculations such as the ones you outline and going on to detailed gaming of the pension system by adapting your strategy to exploit opportunities as they arise, eg, exploiting Tax Credit and pension contribution interactions, changing contribution rates as your income fluctuates or as you have access to salary sacrifice and so on (ie having a more dynamic plan, rather than calculating a long term contribution rate and sticking with it regardless of circumstances).

Assuming NO state pension

Rather pessimistic, but reasonable enough, especially at a young age - not including it gives a cushion of security as you will probably get something.

Personally I don't include State Pension in many of my projections for the reasons you outline, plus I want to retire very early and something that I will receive at about age 70 with a very high degree of uncertainty both about timing and amount (both of which are outside my control) isn't something I want to have any degree of dependence on.

My mortgage, which should represent around 30% of my income throughout my life (assuming I trade up as my salary increases) will be paid off.

Potentially rather inefficient from a tax perspective - depending on circumstances and attitude to risk it may be better to put more into a pension and use it to pay the mortgage in retirement, especially if planning to retire early.

My salary should increase with inflation as should my pension contributions - I'll remove inflation from growth rates to get figures in 'today's money'

Depending on your job, your salary will probably increase a lot faster than inflation over time. Average earnings growth has typically about 1% to 1.5% above RPI, which in turn is about 1% above CPI. So average earnings growth is likely to be about CPI+2%-2.5%. Add to that average earnings includes compositional effects (more expensive older workers leaving the workforce and lower paid younger workers entering) and you may expect your personal earnings to increase above average earnings.

Having said that, some jobs have high pay increases up to a certain level, after which pay increases level-off, so expectations have to be quite a personal calculation.

For my ideal scenario of retiring at 55, I'd take growth rates of 2.5% for real GDP growth (we should return to this eventually) + 2.5% for inflation + 2% for dividend yield = 7.0% long-term total return.

Reasonable enough, but try some other rates of return for sensitivity, drawing on what you are investing in to judge what is reasonable sensitivity.

If growth rates are below this or I happen to reach 55 at the low point of an economic cycle (think 2009-2010), my retirement date would be pushed forward from the ideal age, up to a max age that, for me, I've set at 65.

This depends on how you manage investment risk. If you manage it by moving into safer assets as you approach target age, you are less exposed to volatility, at the cost of a lower expected return. If you stay invested in more volatile assets and manage that by a willingness to work longer if needed, you have a higher expected return but with less certainty.

This would be 20% of annual salary - or 16% personal and 4% company.

I realise these contributions appear crazy

20% isn't crazy - it is a certainly a good contribution rate, but below that of Defined Benefit Schemes.

The NAPF's quality mark plus for DC schemes specifies a minimum employer contribution rate of 10%, which many employers pay.

grey_gym_sock

wow, the amount of thought that OP has already put into this is impressive, especially compared to many posters in this forum!

1StepDebt

<deleted post - my brother had logged into his account and I posted here in error under his account>

marathonic

dunstonh wrote: »

Too high to use for assumptions. You may get it and you hope you would but for forward planning, it is too high.

As well as the GDP + Inflation + Dividend method of calculating potential returns, I looked at average past returns of indexes:

FTSE All Shares Index:

1985: 682
2011: 2858

That's a 319% return over 20 years - incorporating the current crisis into the figures.


S&P 500 Index (as at 2011):

5 year average return: -0.25%
10 year average return: 2.92%
15 year average return: 5.45%
20 year average return: 7.81%
25 year average return: 9.28%

You can see how the recent crisis has skewed the short term returns above but the long term figures look pretty good.


European Shares (as at December 2011):

"since 1970 the price return of MSCI Europe was 5.7%, even though the total return was 9.6%, meaning that 3.9% of the total return came from dividends"


I'm aware that "past performance is not a guide to future performance" but my figures are based around selecting a very low target retirement age with a view to working a little longer if the original assumptions fail to transpire.

This doesn't follow the standard methodology of assumming more pessimistic growth rates and contributing more to the pot monthly.

dunstonh wrote: »

Again, too high for the age of retirement. You need to factor in inflation. An income rate of 2.5% is probably more realistic.

I suppose this is highly dependent on your fund size - which will impact your attitude to risk in retirement. Current annuity rates quoted here are 4.19% for a 55 year old (joint annuity).

Again, I realize what you're saying - the methodology of more pessimistic assumptions to provide for more of a guarantee of meeting your goals upon retirement.

For my purposes of allowing myself to work 3-5 years longer if the original assumptions fail to transpire, I think a 4% annuity assumption is fine.

Obviously, these are not assumptions that someone in the industry could provide to clients which I totally understand.

dunstonh wrote: »

I think that 22% contribution for a 25 year term to be sufficient on income for life is unlikely to be enough.

The figures above are for my personal situation which is 22% for a 25 year term with a starting pot of £40,000 (I decided at a young age to contribute a lot to my pension whilst I'd no other commitments. At it's highest, my own contribution level was at 26% and my employer requested me to reduce this to 20% when the company plan rules changed)

grey_gym_sock

average returns over the last 25 years may be a bit too high, because the 80s and 90s were exceptionally good for shares, which may more than cancel out the 00s being bad.

however, i think 4.5% real return may be fair for equities. i think ppl get figures like 5% or 6% when they take averages over about 100 years.

that is for all-equities, though. if you are more "balanced", i.e. stick a lot of bonds in your portfolio, you might expect less.

for early retirement, the cost of a level annuity isn't that useful, as it will decline in value. drawdown is likely to be better. however, drawing 4% from a portfolio mostly in equities sounds sustainable to me.

kidmugsy

marathonic wrote: »

I'm 30 years old ...

For my ideal scenario of retiring at 55...

Boy, that's ambitious. Compare it with the old university scheme (USS): people might enter it at, say, 25, teach for 40 years and retire at 65 on half pay plus a lump sum equal to three years' pension. They'd therefore draw the pension for about 20 years. They paid 6.35% of salary and their employer something about 16%, so around 22% in all.

And this scheme has proved too expensive for the employers.

Whereas you want to work on for about 25 years and retire for, what, 30 years? You'd need to be lucky.

dunstonh

1985: 682
2011: 2858

That's a 319% return over 20 years - incorporating the current crisis into the figures.

Looking at the period of the credit boom is not realistic looking forward. In the short to medium term there is unlikely to be another credit boom. We rarely learn from our mistakes (there is a lot of similarity with recent events with the 30s). So, there may well be a credit fuelled boom again but dont count on it yet.

A 25 year term will probably only see you invested heavily in equities for about 17 years or so. You will start de-risking from that point and returns will fall for the later years.

I suppose this is highly dependent on your fund size - which will impact your attitude to risk in retirement. Current annuity rates quoted here are 4.19% for a 55 year old (joint annuity).

Again, I realize what you're saying - the methodology of more pessimistic assumptions to provide for more of a guarantee of meeting your goals upon retirement.

For my purposes of allowing myself to work 3-5 years longer if the original assumptions fail to transpire, I think a 4% annuity assumption is fine.

Obviously, these are not assumptions that someone in the industry could provide to clients which I totally understand.

Annuity rates for a 55 year old in 25 years time are likely to be lower as life expectancy will likely be higher. Plus, you are looking at level rates and a level annuity from age 55 is not a good idea.

I dont want to knock ambition and your thought process is what everyone should do but I just feel you are relying on too much on assumptions which are at the higher end.