You must put 20% of your salary towards your pension!
A new report suggests that unless you are putting a fifth of your salary aside to pay for your retirement, you may have an unpleasant surprise in later life.
A report based on the most comprehensive analysis of global investment returns shows that the next generation of investors should expect low returns for the next 20-30 years, and therefore need to save a lot more if they want a good retirement.
The report comes from Elroy Dimson, Paul Marsh and Mike Staunton, three men behind the groundbreaking book, The Triumph of the Optimists: 101 Years of Global Investment Returns, as well as the CSFB Global Investment Returns Yearbooks.
The authors, with the help of researchers all over the world, have put together the most comprehensive and accurate information about historical returns on shares and other assets that you can get anywhere.
Quality research doesn't mean good news
Unfortunately, by stripping out or reducing many of the biases found in other research, and by using more and better information, the authors show that most of the time our investments do worse than we'd expect and worse than we're told.
That's not new. They first demonstrated that back in 2000. What's new from this year's report – the biggest takeaway for individuals like you and me – is that we need to sacrifice a lot more now if we want to earn the retirement income we expect.
The authors estimate that a 25-year-old paying into a pension that relies on investments will need to contribute at least 16%-20% of his salary to retire on half salary at 65. From my own estimates, based on those figures, if you're just five years older, it's a lot tougher still. You might need to contribute 20%-24%.
Why so much?
Using the mass of quality data they have collected, they believe that the most reasonable forecast of investment returns after inflation and costs is just 1%-2% per year for the next 20-30 years. (If you stick solely with cash and earn interest, though, they expect you'll actually be poorer after deducting inflation.)
This very slow growth is actually not unusual, but people's expectations have been raised by the massive investment returns that we experienced in the 1980s and 1990s. Those sorts of gains were extraordinary, however, and we can't expect them to be repeated.
It's not much better if you're on a final salary scheme
You might not be investing your pension contributions. You might be in a company pension scheme that will give you a proportion of your final salary in retirement instead. However, you're not much safer. The authors write:
“In the UK, unfunded public sector pension liabilities (all defined-benefit schemes) are at least £1 trillion, while unfunded state pension liabilities total at least £4.3 trillion. The increased liabilities from the lower interest rates can be met only by raising taxes, by increasing the pension age, or by cutting benefits. These are harsh choices.”
Something will eventually have to give at many firms, and it would be naïve to think that employees won't be forced to take at least some of the hit – again.
Everyone is way too optimistic
The financial regulator is one of the most pessimistic forecasters out there, and yet its medium projection would still result in investment returns after inflation and costs of around double those in this report.
The authors find it worth pointing out that the regulator's most negative forecast is still in positive territory, yet it's not far-fetched for investors to lose money over a couple of decades. It's not the norm, but it happens more than most people think.
They also note: “Interestingly, the UK’s Department for Work and Pensions calculates the prospective wealth of tomorrow’s pensioners using an assumed return that exceeds the most optimistic projection that the [regulator] now permits.”
The Government probably doesn't want to frighten anyone, but the whole industry has even more to lose: it doesn't want people to throw in the towel on the investment services they provide. Hence, they can sometimes be even more upbeat. You still read projections of 6% or more after costs. Guessing precisely how fast investments will grow is impossible, but that is absurdly optimistic.
Wishful thinking doesn't help
Peter Bernstein wrote in a letter to Howard Marks of Oaktree Capital: “The market's not a very accommodating machine; it won't provide high returns just because you need them.”
His point is that you shouldn't go taking bigger risks to get higher returns just because average returns are going to be low. This is called “chasing yield” and it often ends with you losing a lot of money.
It's more complicated than all this
The authors of the report are experts on investment returns, but I doubt they're experts on the benefits system.
How benefits interact with your private wealth and income when you retire is very complicated, so they probably haven't considered a great many scenarios in coming to their estimates.
From my other research it seems that some retirees get far more from the state than they expect (so long as they claim all their benefits). State benefits to retirees have also climbed significantly in the past few decades, but whether that will continue or reverse remains to be seen.
It's also clear from previous research of mine that retirees, on average, need less money than they expect (although everyone is different). There's a fair chance that those earning more than the average wage won't need half of their final salaries, for example.
Consider alternatives to pensions
Although I've explicitly mentioned pensions in this article, you don't just have to save for retirement in a pension. You have share ISAs and peer-to-peer lenders to consider as well, and they both have advantages (and disadvantages) over pensions.
In addition, there's no reason why you can't make it easier on yourself by using your home as part of your pension. You can release equity after you've retired by downsizing or through housing equity-withdrawal, which is a kind of mortgage for life that your estate will pay after you die. The only reason not to do either is if you're determined that your children or someone else should inherit the lot.
For millions of people, downsizing and equity-withdrawal currently have advantages thanks to the retirement benefits system. By withdrawing equity from your home only when you need it, you can continue to be paid most of your income benefits.
> Fancy winning £50? We’ve got five £50 prizes in a draw for anyone who answers one of our Lovemoney surveys.
More on pensions:
Lifestyling: the 'low risk' pension tactic that could decimate your pot
What is income drawdown?
What to do if you are retired and still in debt
Why equity release should only be a last resort
How to top up your State Pension
How to consolidate your pensions
How can pensioners in the same situation get different benefits?
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Thanks meldrewreborn You write: "Read the headline again and then the first sentence. Retirement saving = pension? NOT TRUE." You're right, but I almost certainly didn't write the title. I usually don't. The article itself refers to "retirement saving" and you obviously didn't make it to the end, where I saved several paragraphs for alternatives to pensions. I always try to squeeze in and big up the alternatives to pensions wherever I can, space permitting. Thanks Neil
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Neil falls into the common trap. Read the headline again and then the first sentence. Retirement saving = pension? NOT TRUE. A pension is one way of saving for retirment, it isn't for everybody and pensions are notoriously inflexible and subject to the whims of the government of the day. And from the first contribution to when you collect might be 50 years so there's plenty of scope for HMG to screw you. So yes, save for retirement, but the old investment addage of not putting all your eggs into one basket should still apply.
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Well, twenty years of pension contributions have been flushed down the toilet, so no one is getting any more of my money. Even savings accounts aren't safe. I know that there is a government scheme to protect savings in Banks operated under this scheme, but if the government fails, then even they cannot protect savings (or they may pass an emergency law allowing them to raid savings). Remember that the biggest thieves are politicians. The rest of the country can starve to death, but you will never see a poor politician eating spam. While the rest of us are eating slop, they'll be dining on roast pork. So, should I put aside 20% of my wages for the future? Well, considering that after my allowance, I pay 20% tax, NI, 20% VAT, premium tax on insurances, and other assorted taxes, the answer is NO. If our government want us to put aside more money, they need to allow us to have some of our existing money back. Being taxed at approximately 50%, or more for higher tax payers, is not fun. Around half of our working population are already on the breadline, according to the ONS, and around 1.5 million are reliant on regular Pay Day loans, so putting aside 20% of what they don't have is not going to work. How many people here work out what they earn, and what they spend, each month? How many could afford to lose one fifth of their money earnings? How many can afford to cut back to put one fifth of their money aside, without suffering a lesser quality of life? Pensions are all well and good if you are earning an excess you can afford to lose, but wages and salaries have not kept up with inflation over the years. I now earn less than what I was earning some twenty years ago, and that was when prices were a lot cheaper. Some of the problem is that our labour market has been swamped with immigrants who are more than happy to do skilled work for minimum wage, driving down the salaries earned for these jobs. A classic example are driving jobs, where the minimum wage used to be in excess of £10 an hour, but now sits at £7.50 an hour. Also, a lot of warehouses now use cheaper foreign labour who don't complain about the lack of wages. This may be good for business, but is bad for the population who have seen nothing but pay freezes for the four of five years. The law of economics is that if you don't share the wealth, you don't spend the wealth. The more you pay someone, the more they spend, which in turn will promote further spending. Money sat in the bank does little for the economy. For example, if one person has £1 million sat in their account, they will earn a modest interest (if they are lucky), but divide that £1 million between 100 people and they will spend it, strengthening the economy slightly. The economy runs on money (or goods and services) changing hands continuously. If this stops, so does the economy. Too many big institutions are trying to horde money. If a bog company makes little or no profit, as long as its employees and employers get their monthly pay, then all is good. Too much emphasis is made about 'profit'. A company need only earn enough to cover running costs to keep the status quo. (I know of several companies where there is little profit to be made, but the employees are directors are happy, because they are earning).
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06 November 2013