Work Out What Pension Pot You Need

We show you how to estimate the pot of money you'll need in order to retire comfortably.

This is the third part in a three-part series that will help you to work out what size pension pot you need to retire comfortably, and how much you need to save to get there.

The Four-Step Guide To A Comfortable Retirement: Part Three

Now I'm going to show you how to use your target retirement income to work out the retirement pot you need to save. (Bit of a tongue-twister, that.)

Typically, people have no target pot, or they rely on industry estimates, or worse still they have no target whatsoever. Here's a more personalised approach.

(At The Fool we do our best to simplify personal finance issues and remove all the jargon, but I regret that this exercise is a little bit more complex than usual. Still, I'll do my best...)

1. Understanding annuities

When most people retire they use their pension pots to buy annuities, which is a pension income for the rest of your life. The bigger the pot, the bigger your monthly pension.

You really need to understand annuities before you can read any further, because there is some unavoidable jargon coming up.

To get a simple explanation, see What Is An Annuity? in All About Annuities. Make sure you take in what factors can affect the size of your annuity, such as your gender and whether you smoke. You should also ensure you understand terminology such as 'level annuity', 'joint-life' and 'guarantee periods'.

2. Compare annuities

Next you need to look at annuity rates, which you can do using the Financial Services Authority's comparison tables. These tables only include a small number of annuity providers, but it's good enough for our purposes.

Firstly...

Go to the FSA's Annuity Tables
Click on 'Go To Tables'
Click on the image that looks like a grid to the right of 'Pension annuities' (near the bottom)
Click on 'Go to Pension Annuities table'
Select 'Yes' and click 'Continue'.

You then have to answer a series of questions to get your personalised table. One of the questions (Q4) asks what pension pot you have. As you are trying to work out what pension pot you'll need, you can't yet answer that question yet. So...

For mathematicians

There are two ways to go about finding the answer. The first way is for the mathematicians amongst you, who will be able to work it out quickly enough by typing, say, £100,000 in Q4 and getting a set of results, from which you'll be able to work out the pension pot you need.

(Bear in mind that the size of pot you enter can also affect the annuity rate you get, but this method should be accurate enough for this exercise.)

For non-mathematicians

For non-mathematicians, I suggest a trial-and-error approach.

If you struggle with the following method, or if you want someone to suggest another method, you should visit our Pensions - Practical Problems discussion board. Post details there of your target retirement income and the age you want to retire at, and ask the helpful folks on the board to help you.

But give this a go first!

Fill in the FSA's questions. In Q4, type in, say, twenty times the income you need. (In my case it's £49,000 x 20 = £980,000.)
You'll then get a table displaying several annuity providers' rates. The figures you see are monthly income rates. Study the table for the highest paying annuity of the type you want, i.e. level, rising by 3% per year, or rising by RPI (the Retail Prices Index - inflation).
Multiply that figure by 12 to get the annual income.
If the annual income figure is higher or lower than your target, go back to the first page of questions and change the answer in Q4 appropriately. Use your best guess.
Keep doing this until you have an answer that's pretty close to the annual income you need.

Sadly, in Q4 of the FSA's tool you can't enter a pension pot of more than £999,999. If you require a pension pot over this amount:

Answer all the questions and type 999999 in Q4.
Find the monthly figure as before.
Multiply it by 12 to get the annual income.
Use trial-and-error again. To do this, multiply the annual income figure by, say, 1.10. If this gets close enough to the income you require, then the pension pot you need is £1.1m. If you still need a little more, try multiplying it by 1.15. If this is roughly the income you require, then the pot you need is £1.15m.
If you need a lot more, try 1.2, 1.3 or 1.4 etc, which will mean pots of £1.2m, £1.3m and £1.4m. Keep going till you're satisfied that your figure is close enough to your target.

My figures

I did this three times to get several different annuity rates. Assuming I retire in 40 years, using my own personal details I found that in order to get my target starting pension of £49,000 I need to aim for a pot of:

£730,000 for a level annuity
£1,020,000 for an annuity rising at 3% per year or
£1,140,000 for an annuity rising with inflation.

3. Problems

There is a problem with this exercise, which is that it is based on today's annuity rates. But you're not retiring today, are you? Annuities and annuity rates will change as time goes by, so that perhaps they'll be vastly different when you finally burn your ties or...whatever it is that women burn when they stop work.

To manage this problem, I suggest you re-visit this whole exercise from the start once a year. By doing this, you can see how your expectations for retirement may have changed, and you can make sure you're still on track.

From year to year, you may find that you need to increase your retirement savings a little, or that you can even decrease them.

I believe that this is far better than having no target, or no clue as to what size retirement pot to aim for.

4. Next!

I've decided to add a fourth part to this three-part series,* which will show you how to work out the amount you should save in order to build your retirement pot.

I'm sure that there must be better annuity tools than the FSA one I used, so if anyone has any recommendations, please let other readers know by posting your comments on the TMF Article Feedback board.

You've been reading part three!
Go back to part two
Go forward to part four

*A trilogy in four parts, as Douglas Adams (author of The Hitchhikers Guide to the Galaxy) would say.